Recursive Profit-and-Loss Sharing

Abstract

This paper develops a new financial product that allows the profit-and-loss sharing (PLS) principle to be enforced recursively in practice. A new equity-like financial product is proposed through a three-tier partnership to which a new contracting party (the risk moderator) is added to absorb the underlying risk of premature default and adjust the annual revenue to a predetermined annual cost. The financing mechanism pioneers a new type of option, dubbed the PLS option, to manage the underlying risk of revenue sharing. A dynamic capital structure methodology is developed for the valuation of the PLS option that allows for an annual adjustment of the project's revenue and recalculates the entitlements pertaining to contracting parties. Monte Carlo simulation is conducted to evaluate the project when the construction cost is deterministic and the streams of expected cashflows are stochastic. The simulation results show that the dynamic adjustment of the capital structure simultaneously endorses a recursive profit-and-loss sharing and a dynamic risk-hedging approach. Sheer evidence shows the immunization against premature default through the involvement of the risk moderator to absorb any potential loss, which is indicative of an incentive factor for the project's survival and business continuity.