Public guarantees for mitigating interest rate risk in PPP projects

Purpose: The purpose of this paper is to deal with the maximum interest rate guarantees (MIRGs), and develop a methodology for setting the optimal value of the interest rate cap, namely the maximum interest rate above which the private investor will obtain reimbursement from the government, which balances the interests of the parties involved in the project. Design/methodology/approach: The mechanism underlying the MIRG is modeled through real options. Monte Carlo simulation is employed as the option-pricing method. The resulting real option-based model is applied to the case of the “Camionale di Bari” toll road (Southern Italy). Findings: The application provides some insights for the policy maker called to define the proper forms of guarantees. Furthermore, the results support the negotiation process, allowing the different actors to structure the guarantee in a way that satisfies all the parties and fairly allocates risks between them according to different operational and financial conditions. Originality/value: The novelty of the contribution is triple. First, the authors advance the state of the art on government supports by focusing on the interest rate guarantee. Second, the authors enrich the existing studies on MIRG by proposing a quantitative model to set the guarantee in compliance with the public–private win-win principle. The developed real option-based model supports the decision maker in finding the optimal value of the interest rate cap, which is able to satisfy the interests of the parties involved in the project. Third, the authors consider not only the private sponsor and the government, as traditionally made by the models developed for other guarantees, but also the lender.