Pricing of Credit Default Swaps from the Perspective of Credit Enhancement in PPP Projects

The difficulty in financing has become the primary obstacle in the process of promoting a public-private partnership (PPP). Asset securitization is a financial model that can exchange the predictable cash flow of illiquid PPP project assets with the current cash flow, and credit enhancement is crucial in this process. Different from the traditional external credit enhancement of PPP projects based on government guarantees, this paper introduces an innovative credit risk management tool, i.e., credit default swaps (CDS), into the process of asset securitization in the PPP model. In order to avoid opportunistic behavior caused by information asymmetry in the process of financial product transaction, a CDS trading contract between PPP project investors and risk management institutions based on the principal-agent theory and a flexible CDS pricing model is proposed. Through a demonstration case of the Leshan to Rongjiang Expressway in China, the volatility correlation among CDS contract default probability, pricing, and related factors, such as default limits, operation period, compensation amount, project investment return, investment return volatility, and PPP project investors' expected inputs, is obtained. The study shows that (1) appropriate CDS pricing helps to generate investors' high expected inputs and diligence with controls; (2) there is a positive correlation between the change of default limit and compensation amount, and the set value of default limit should not be too high, otherwise it may induce the increase of default probability; and (3) based on the high return on assets and moderate asset volatility of PPP projects, the probability of default of CDS contracts is low. The innovative financial mechanism developed by the principal-agent theory could enrich the credit enhancement methods in asset securities of PPP projects.