The paper examines a potential role of financing Africa’s infrastructure projects, particularly in Africa, with bonds indexed to the project. Using option-pricing techniques, the author shows that an infrastructure indexed bond is equivalent to a regular bond and a short position on a European put option. The results of the paper suggest that the value of the infrastructure indexed bond increases monotonically as the value of the project it is financing rises. In addition, the market value of the infrastructure-indexed bonds falls as the value of the project becomes more volatile. The rise in the dividend rate on the project is observed to have an adverse effect on the value of infrastructure-indexed bonds.
The author examines the role of collateral in an environment where lenders and borrowers possess identical information and similar beliefs about its future value. Using option-pricing techniques, he shows that a secured loan contract is equivalent to a regular bond and an embedded option to the borrower to default. The author finds that the lender will not advance to the borrower, a loan that exceeds the market value of the collateral, and that the supply of loans increases with a rise in the market value of the collateral. Increases in the volatility of the value of the collateral, interest rate, and dividend rate of the collateral independently depress the loan supply. The author also derives the cost of a third-party guarantee of a loan and an implied risk premium.