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A New Model for Pricing Collateralized Financial Derivatives

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  • Tim Xiao

    (University of Toronto)

Abstract

This paper presents a new model for pricing financial derivatives subject to collateralization. It allows for collateral arrangements adhering to bankruptcy laws. As such, the model can back out the market price of a collateralized contract. This framework is very useful for valuing outstanding derivatives. Using a unique dataset, we find empirical evidence that credit risk alone is not overly important in determining credit-related spreads. Only accounting for both collateral posting 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 derivatives. We also empirically gauge the impact of collateral agreements on risk measurements. Our findings indicate that there are important interactions between market and credit risk.

Suggested Citation

  • Tim Xiao, 2017. "A New Model for Pricing Collateralized Financial Derivatives," Post-Print hal-01800559, HAL.
  • Handle: RePEc:hal:journl:hal-01800559
    Note: View the original document on HAL open archive server: https://hal.archives-ouvertes.fr/hal-01800559
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    File URL: https://hal.archives-ouvertes.fr/hal-01800559/document
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    References listed on IDEAS

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    1. 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.
    2. Mark Grinblatt, 2001. "An Analytic Solution for Interest Rate Swap Spreads," International Review of Finance, International Review of Finance Ltd., vol. 2(3), pages 113-149, September.
    3. Hua He, 2000. "Modeling Term Structures of Swap Spreads," Yale School of Management Working Papers ysm150, Yale School of Management, revised 01 Mar 2001.
    4. Feldh├╝tter, Peter & Lando, David, 2008. "Decomposing swap spreads," Journal of Financial Economics, Elsevier, vol. 88(2), pages 375-405, May.
    Full references (including those not matched with items on IDEAS)

    More about this item

    Keywords

    collateralization; asset pricing; plumbing of financial system; swap premium spread; CVA;

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