Real option, debt maturity and equity default swaps under negotiation

- We consider a firm with no assets in place but an investment option.
- The firm enters into fee-for-guarantee swap (FGS) or equity-for-guarantee swap (EGS).
- Debt has a finite maturity and guarantee cost depends on negotiation.
- Guarantee cost increases with funding gap but it may conversely decrease as well.
- The option value decreases first and then increases with debt maturity.

We consider an investment option, of which the sunk cost is financed by entering into a fee-for-guarantee swap (FGS) or equity-for-guarantee swap (EGS). Debt has a finite maturity and guarantee costs depend on negotiation. We explicitly derive guarantee costs and the pricing and timing of the option. Under negotiation, borrowers get partial option value depending on his bargaining power and insurers gain the remaining value. We discover that EGSs are better than FGSs in borrowers' view. Guarantee costs generally increase with funding gaps and investment thresholds decrease with debt maturities. The option value decreases first and then increases with debt maturity.