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Modeling of Interest Rate Term Structures under Collateralization and its Implications

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  • Masaaki Fujii

    (The University of Tokyo)

  • Akihiko Takahashi

    (The University of Tokyo)

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    Abstract

    In recent years, we have observed dramatic increase of collateralization as an important credit risk mitigation tool in over the counter (OTC) market [6]. Combined with the significant and persistent widening of various basis spreads, such as Libor-OIS and cross currency basis, the practitioners have started to notice the importance of difference between the funding cost of contracts and Libors of the relevant currencies. In this article, we integrate the series of our recent works [1, 2, 4] and explain the consistent construction of term structures of interest rates in the presence of collateralization and all the relevant basis spreads, their no-arbitrage dynamics as well as their implications for derivative pricing and risk management. Particularly, we have shown the importance of the choice of collateral currency and embedded hcheapestto-deliverh (CTD) option in a collateral agreement.

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    File URL: http://www.carf.e.u-tokyo.ac.jp/pdf/workingpaper/fseries/240.pdf
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    Bibliographic Info

    Paper provided by Center for Advanced Research in Finance, Faculty of Economics, The University of Tokyo in its series CARF F-Series with number CARF-F-230.

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    Length: 20 pages
    Date of creation: Sep 2010
    Date of revision: Dec 2010
    Handle: RePEc:cfi:fseres:cf230

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