A new model for pricing collateralized financial derivatives
Journal of Derivatives , Volume 24 - Issue 4 p. 8- 20
This article presents a new model for pricing financial derivatives subject to collateralization. It allows for collateral arrangements 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, the author finds empirical evidence that credit risk alone is not overly important in determining credit-related spreads. Only accounting for both collateral posting 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. The author also empirically gauges the impact of collateral agreements on risk measurements. The findings indicate that there are important interactions between market and credit risk.