Credit risk in infrastructure PPP projects under the real options approach

Abstract The purpose of the paper is to provide a method to estimate the credit risk in infrastructure public–private partnership (PPP) projects by using a structural model, the Real Options approach, and the Monte Carlo simulation technique. To do that, previous models are extended under a structural framework for credit risk where the embedded options in the credit agreement such as the option to renegotiate and the option to exit are introduced as well as the uncertainty of the cash flows. In that sense, all the components of expected loss (EL) such as the probability of default, the exposure, and the recovery rate for lenders are modelled and estimated in a PPP toll road project by considering the embedded options as well as the default events. Consequently, it is found that the embedded options improve the recovery rate for lenders and their EL. Additionally, practical insights about the effects of the embedded options in the credit agreement and the probability of default are provided.