Collateral-Enhanced Default Risk
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.
References listed on IDEAS
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- Merton, Robert C, 1974.
"On the Pricing of Corporate Debt: The Risk Structure of Interest Rates,"
Journal of Finance,
American Finance Association, vol. 29(2), pages 449-470, May.
- 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.
- 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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