A New Model for Pricing Collateralized OTC Derivatives

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Project Citation:

Xiao, Tim. A New Model for Pricing Collateralized OTC Derivatives. Ann Arbor, MI: Inter-university Consortium for Political and Social Research [distributor], 2020-05-19. https://doi.org/10.3886/E112150V1

Project Description

Summary: This paper presents a new model for pricing OTC derivatives subject to collateralization. It allows for collateral posting adhering to bankruptcy laws. As such, the model can back out the market price of a collateralized contract. This framework is very useful for valuing outstanding derivatives. Using a unique dataset, we find empirical evidence that credit risk alone is not overly important in determining credit-related spreads. Only accounting for both collateral arrangement and credit risk can sufficiently explain unsecured credit costs. This finding suggests that failure to properly account for collateralization may result in significant mispricing of derivatives. We also empirically gauge the impact of collateral agreements on risk measurements. Our findings indicate that there are important interactions between market and credit risk.

Scope of Project

Subject Terms: collateralization; asset pricing; plumbing of financial system; swap premium spread; CVA; VaR; interaction between market and credit risk

Geographic Coverage: US, Canada, EUR

Time Period(s): 2000 – 2015

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