Risk Measurement for Project Finance Guarantees

Abstract

This article presents a methodology for quantifying the risk of financial guarantees to structured projects such as toll-roads. The results answer the following questions: how much should be charged for giving the guarantee, what is the effective subsidy, what reserve is required to protect against potential future losses, and what is the loss profile over the life of the project. Importantly, the analysis uses Monte Carlo evaluation to calculate the portfolio effects of diversification and correlation among projects. The article lays out the methodology, discusses the policy implications, and gives concrete illustrations of the approach by calculating examples of guarantees to a toll road and a bank. The discussion focuses on the management of a guarantee program by a government. The framework also can be used for other government contingent liabilities and can be used by banks and project finance companies to structure projects, price portfolios, and arbitrage.