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Collateral-Enhanced Default Risk

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  • Chris Kenyon
  • Andrew Green

Abstract

Changes in collateralization have been implicated in significant default (or near-default) events during the financial crisis, most notably with AIG. We have developed a framework for quantifying this effect based on moving between Merton-type and Black-Cox-type structural default models. Our framework leads to a single equation that emcompasses the range of possibilities, including collateralization remargining frequency (i.e. discrete observations). We show that increases in collateralization, by exposing entities to daily mark-to-market volatility, enhance default probability. This quantifies the well-known problem with collateral triggers. Furthermore our model can be used to quantify the degree to which central counterparties, whilst removing credit risk transmission, systematically increase default risk.

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  • Chris Kenyon & Andrew Green, 2013. "Collateral-Enhanced Default Risk," Papers 1302.4595, arXiv.org.
    • Handle: RePEc:arx:papers:1302.4595
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    References listed on IDEAS

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    3. Mark Broadie & Paul Glasserman & Steven Kou, 1997. "A Continuity Correction for Discrete Barrier Options," Mathematical Finance, Wiley Blackwell, vol. 7(4), pages 325-349, October.
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