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.
- Creative Commons: Attribution CC BY
- Creator: Xiao, Tim
- Language: English
- Publisher: Journal of Derivatives
- Year: 2020-07-13
Get a copy of the report
I agree to use the research in according to the terms of copyright and Creative Commons Licence. For details of Creative Commons licenses visit - https://creativecommons.org/licenses/