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A New Model for Pricing Collateralized OTC Derivatives

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  • Xiao, Tim

Abstract

ABSTRACT 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. https://frenxiv.org/am8zy/download

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  • Xiao, Tim, 2017. "A New Model for Pricing Collateralized OTC Derivatives," FrenXiv am8zy, Center for Open Science.
    • Handle: RePEc:osf:frenxi:am8zy
    DOI: 10.31219/osf.io/am8zy
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    1. 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.
    2. 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.
    3. Xiao, Tim, 2013. "An Accurate Solution for Credit Value Adjustment (CVA) and Wrong Way Risk," MPRA Paper 47104, University Library of Munich, Germany.
    4. Feldhütter, Peter & Lando, David, 2008. "Decomposing swap spreads," Journal of Financial Economics, Elsevier, vol. 88(2), pages 375-405, May.
    5. 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.
    6. Hua He, 2000. "Modeling Term Structures of Swap Spreads," Yale School of Management Working Papers ysm150, Yale School of Management, revised 01 Mar 2001.
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    Cited by:

    1. Xiao, Tim, 2018. "The Valuation of Credit Default Swap with Counterparty Risk and Collateralization," EconStor Preprints 203447, ZBW - Leibniz Information Centre for Economics.
    2. Xiao,Tim, 2018. "Pricing Financial Derivatives Subject to Multilateral Credit Risk and Collateralization," EconStor Preprints 202075, ZBW - Leibniz Information Centre for Economics.

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