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Collateral-Enhanced Default Risk

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  • Chris Kenyon
  • Andrew Green
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    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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    File URL: http://arxiv.org/pdf/1302.4595
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    Bibliographic Info

    Paper provided by arXiv.org in its series Papers with number 1302.4595.

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    Date of creation: Feb 2013
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    Handle: RePEc:arx:papers:1302.4595

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    Web page: http://arxiv.org/

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    1. Merton, Robert C., 1973. "On the pricing of corporate debt: the risk structure of interest rates," Working papers 684-73., Massachusetts Institute of Technology (MIT), Sloan School of Management.
    2. Mark Broadie & Paul Glasserman & Steven Kou, 1997. "A Continuity Correction for Discrete Barrier Options," Mathematical Finance, Wiley Blackwell, vol. 7(4), pages 325-349.
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