Risk transfer in project finance loans for toll road using credit default swaps

Purpose: The purpose of this paper is to demonstrate the applicability of the Credit Default Swaps (CDS), as a financial instrument, for transferring of risk in project finance loans. Also, an equation has been derived for pricing of CDS spreads. Design/methodology/approach: The debt service cover ratio (DSCR) is modeled as a Brownian Motion (BM) with a power-law model fitted to the mean and half-variance of the existing data set of DSCRs. The survival probability of DSCR is calculated during the operational phase of the project finance deal, using a closed-form analytical method, and the results are verified by Monte Carlo simulation (MCS). Findings: It is found that using the power-law model yields higher CDS premiums. This in turn confirms the necessity of conducting rigorous statistical analysis in fitting the best performing model as uninformed reliance on constant time-invariant drift and diffusion model can erroneously result in smaller CDS spreads. A sensitivity analysis also shows that the results are very sensitive to the recovery rate and cost of debt values. Originality/value: Insufficiency of free cash flow is a major risk in the toll road project finance and hence there is a need to develop innovative financial instruments for risk management. In this paper, a novel valuation method of CDS is proposed assuming that DSCR follows the BM stochastic process.