A New Model for Pricing Collateralized Financial Derivatives

TL;DR

This paper introduces a novel model for pricing collateralized derivatives that incorporates legal collateral arrangements, providing a more accurate valuation method and revealing the importance of collateralization in risk and spread analysis.

Contribution

The paper develops a new pricing model that explicitly accounts for collateral arrangements and legal considerations, enhancing derivative valuation accuracy.

Findings

Credit risk alone does not significantly influence credit spreads.

Properly modeling collateralization is crucial for accurate derivative pricing.

Collateral agreements impact the interaction between market and credit risk.

Abstract

This paper 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, we find 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. 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.