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An Economic Examination of Collateralization in Different Financial Markets

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  • Xiao, Tim
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    Abstract

    Tim Xiao: This paper attempts to assess the economic significance and implications of collateralization in different financial markets, which is essentially a matter of theoretical justification and empirical verification. We present a comprehensive theoretical framework that allows for collateralization adhering to bankruptcy laws. As such, the model can back out differences in asset prices due to collateralized counterparty risk. This framework is very useful for pricing outstanding defaultable financial contracts. By using a unique data set, we are able to achieve a clean decomposition of prices into their credit risk factors. We find empirical evidence that counterparty risk is not overly important in credit-related spreads. Only the joint effects of collateralization 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 financial contracts. We also analyze the difference between cleared and OTC markets.

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    Bibliographic Info

    Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 47371.

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    Date of creation: 01 May 2012
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    Handle: RePEc:pra:mprapa:47371

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    Related research

    Keywords: unilateral/bilateral collateralization; partial/full/over collateralization; asset pricing; plumbing of the financial system; swap premium spread; OTC/cleared/listed financial markets.;

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    1. Manmohan Singh, 2010. "Collateral, Netting and Systemic Risk in the OTC Derivatives Market," IMF Working Papers 10/99, International Monetary Fund.
    2. Daniel Heller & Nicholas Vause, 2012. "Collateral requirements for mandatory central clearing of over-the-counter derivatives," BIS Working Papers 373, Bank for International Settlements.
    3. 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.
    4. Mark Grinblatt, 2002. "An Analytic Solution for Interest Rate Swap Spreads," Yale School of Management Working Papers, Yale School of Management ysm39, Yale School of Management.
    5. Feldhütter, Peter & Lando, David, 2008. "Decomposing swap spreads," Journal of Financial Economics, Elsevier, Elsevier, vol. 88(2), pages 375-405, May.
    6. Hull, J., 2010. "OTC derivatives and central clearing: can all transactions be cleared?," Financial Stability Review, Banque de France, Banque de France, issue 14, pages 71-78, July.
    7. Duffie, Darrell & Singleton, Kenneth J, 1999. "Modeling Term Structures of Defaultable Bonds," Review of Financial Studies, Society for Financial Studies, Society for Financial Studies, vol. 12(4), pages 687-720.
    8. Michael Johannes & Suresh Sundaresan, 2007. "The Impact of Collateralization on Swap Rates," Journal of Finance, American Finance Association, American Finance Association, vol. 62(1), pages 383-410, 02.
    9. Duffie, Darrell & Huang, Ming, 1996. " Swap Rates and Credit Quality," Journal of Finance, American Finance Association, American Finance Association, vol. 51(3), pages 921-49, July.
    10. Pierre Collin-Dufresne, 2001. "On the Term Structure of Default Premia in the Swap and LIBOR Markets," Journal of Finance, American Finance Association, American Finance Association, vol. 56(3), pages 1095-1115, 06.
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