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An Economic Examination of Collateralization in Different Financial Markets

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  • Xiao, Tim

Abstract

This paper attempts to assess the economic significance and implications of collateralization in different financial markets, which is essentially a matter of theoretical justification and empirical verification. We present a comprehensive theoretical framework that allows for collateralization adhering to bankruptcy laws. As such, the model can back out differences in asset prices due to collateralized counterparty risk. This framework is very useful for pricing outstanding defaultable financial contracts. By using a unique data set, we are able to achieve a clean decomposition of prices into their credit risk factors. We find empirical evidence that counterparty risk is not overly important in credit-related spreads. Only the joint effects of collateralization 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 financial contracts. We also analyze the difference between cleared and OTC markets.

Suggested Citation

  • Xiao, Tim, 2018. "An Economic Examination of Collateralization in Different Financial Markets," arabixiv.org b7uvg, Center for Open Science.
    • Handle: RePEc:osf:arabix:b7uvg
    DOI: 10.31219/osf.io/b7uvg
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    References listed on IDEAS

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    1. Michael Johannes & Suresh Sundaresan, 2007. "The Impact of Collateralization on Swap Rates," Journal of Finance, American Finance Association, vol. 62(1), pages 383-410, February.
    2. Xiao, Tim, 2011. "An Efficient Lattice Algorithm for the LIBOR Market Model," EconStor Open Access Articles and Book Chapters, ZBW - Leibniz Information Centre for Economics, vol. 19(1), pages 25-40.
    3. Daniel Heller & Nicholas Vause, 2012. "Collateral requirements for mandatory central clearing of over-the-counter derivatives," BIS Working Papers 373, Bank for International Settlements.
    4. Mark Grinblatt, 2001. "An Analytic Solution for Interest Rate Swap Spreads," International Review of Finance, International Review of Finance Ltd., vol. 2(3), pages 113-149, September.
    5. Mr. Manmohan Singh, 2010. "Collateral, Netting and Systemic Risk in the OTC Derivatives Market," IMF Working Papers 2010/099, International Monetary Fund.
    6. Pierre Collin‐Dufresne & Bruno Solnik, 2001. "On the Term Structure of Default Premia in the Swap and LIBOR Markets," Journal of Finance, American Finance Association, vol. 56(3), pages 1095-1115, June.
    7. Hull, J., 2010. "OTC derivatives and central clearing: can all transactions be cleared?," Financial Stability Review, Banque de France, issue 14, pages 71-78, July.
    8. Feldhütter, Peter & Lando, David, 2008. "Decomposing swap spreads," Journal of Financial Economics, Elsevier, vol. 88(2), pages 375-405, May.
    9. Jun Liu & Francis A. Longstaff & Ravit E. Mandell, 2006. "The Market Price of Risk in Interest Rate Swaps: The Roles of Default and Liquidity Risks," The Journal of Business, University of Chicago Press, vol. 79(5), pages 2337-2360, September.
    10. Duffie, Darrell & Singleton, Kenneth J, 1999. "Modeling Term Structures of Defaultable Bonds," The Review of Financial Studies, Society for Financial Studies, vol. 12(4), pages 687-720.
    11. Hua He, 2000. "Modeling Term Structures of Swap Spreads," Yale School of Management Working Papers ysm150, Yale School of Management, revised 01 Mar 2001.
    12. Duffie, Darrell & Huang, Ming, 1996. "Swap Rates and Credit Quality," Journal of Finance, American Finance Association, vol. 51(3), pages 921-949, July.
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    Cited by:

    1. Xiao, Tim, 2013. "An Accurate Solution for Credit Value Adjustment (CVA) and Wrong Way Risk," MPRA Paper 47104, University Library of Munich, Germany.

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    More about this item

    JEL classification:

    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G18 - Financial Economics - - General Financial Markets - - - Government Policy and Regulation
    • G24 - Financial Economics - - Financial Institutions and Services - - - Investment Banking; Venture Capital; Brokerage
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill
    • G33 - Financial Economics - - Corporate Finance and Governance - - - Bankruptcy; Liquidation

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