Contingent Liabilities: Issues and Practice; Aliona Cebotari; imf working Paper 08/245; October 1, 2008

The choice of method depends generally on the existence of comparable companies 
and the cost of the method. Implicit guarantee valuations are used when it is relatively 
easy to find companies comparable to the borrower that issue debt quoted in the market. If 
these are difficult to find, simulation methods are frequently used, but these are both time-
consuming and expensive to develop. To justify such an investment of resources, the 
guaranteed amounts have to be large. In cases where the guarantees are relatively small 
and there is thus no reason to develop a simulation model, an option pricing model may be 
a good substitute (Hagelin, 2003). Any reasonable approach, including educated guesses, 
will produce better estimates of the cost of loan guarantees than the cash-based approach 
that will always assume zero cost in the budget year. 
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Merton (1977) demonstrated that a government guarantee to banks could be modeled as an implicit put 
option. 

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Figure A1. The Swedish Debt Office Simulation Model 
Source: Hagelin, 2003. 

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57
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