On the Valuation of Private Loan Guarantees : Wealth Effects and Government Insurance Protection

Merton and Bodie (1992) show that third-party financial guarantees are overwhelming pervasive. Using the risk-neutral valuation framework of Brennan (1979) and Stapleton and Subrahmanyam (1984), without imposing any no loss-no gain condition on stockholders and debtholders, we examine the impact of third-party loan guarantees (both private of government) on different financial claims of the borrowing firm. We also study the values of private loan guarantees with ultimate government backup insurance protection. To derive comparative statics for various type of loan guarantees, we conduct numerical simulations of the resulting closed-form formulas