An application of an option pricing model to evaluate the cost of a government loan guarantee : an hypothetical case based on Eskom
Master Thesis
1995
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University of Cape Town
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Abstract
In the late 1930s, the Great Depression and its consequences led to the U.S federal government's intervention in credit assistance and insurance programmes. The main reason for this intervention was that there was a general desire to rescue individuals and businesses which were unable to repay their debts when due. Considerable debate has focused on the determination of the magnitude of the government liabilities resulting from guaranteed loan re-payments. Today, most nations, including South Africa, employ such government guarantees, but they are often improperly valued; that is, one has no idea whether such guarantees are 'good ' or 'bad' policy tools. This paper illustrates how Put option pricing models may be used to estimate the 'real' cost to the South African government of a loan guarantee to Eskom, which is investing a large hydroelectric project in Mozambique, hypothetically assuming that Eskom has been privatized. While the paper recognises the importance of the insurance premium which could be charged by the government for its loan guarantee, the results under the hypothetical case show that the Eskom is able to readily repay the promised payment and, thus, the loan guarantee provides value to Eskom's owners. In this regard, one can argue that parties involved in such a project, such as the South African government, Eskom and the European agencies may benefit from the loan guarantee programme. Thus, a loan guarantee programme may be seen as a 'good' policy tool to resolve conflicts between lenders and borrowers, to encourage investment and to meet a broader public interest.
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Bibliography: pages 78-81.
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M'pasi, A. 1995. An application of an option pricing model to evaluate the cost of a government loan guarantee : an hypothetical case based on Eskom. University of Cape Town.