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Choice of Collateral Currency

  • Masaaki Fujii

    (Graduate School of Economics, University of Tokyo)

  • Akihiko Takahashi

    (Faculty of Economics, University of Tokyo)

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    Collateral has been used for a long time in the cash market and we have also experienced significant increase of its use as an important credit risk mitigation tool in the derivatives market for this decade. Despite its long history in the financial market, its importance for funding has been recognized relatively recently following the explosion of basis spreads in the crisis. This paper has demonstrated the impact of collateralization on derivatives pricing through its funding effects based on the actual data of swap markets. It has also shown the importance of the "choice" of collateral currency. In particular, when a contract allows multiple currencies as eligible collateral as well as its free replacement, the paper has found that the embedded "cheapest-todeliver" option can be quite valuable and significantly change the fair value of a trade. The implications of these findings for risk management have been also discussed.

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    File URL: http://www.carf.e.u-tokyo.ac.jp/pdf/workingpaper/fseries/249.pdf
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    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-239.

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    Length: 15 pages
    Date of creation: Dec 2010
    Date of revision:
    Handle: RePEc:cfi:fseres:cf239
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