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Modeling Collateralization and Its Economic Significance

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  • Lee, David

Abstract

ABSTRACT This article presents a new model of collateralization. We study the economic impact of collateralization on the plumbing of the financial system. The model gives an integrated view of different collateral arrangements. We show that the effect of collateral on asset prices is significant. Our study shows that a poorly designed collateral agreement can actually increase credit risk. We find evidence that collateral posting regimes that are originally designed and utilized for contracts subject to bilateral credit risk (e.g., a swap) may not work properly for contracts subject to multilateral credit risk (e.g., a CDS) in the presence of default correlations. These findings contradict the prevailing beliefs in financial markets about collateralization.

Suggested Citation

  • Lee, David, 2023. "Modeling Collateralization and Its Economic Significance," MPRA Paper 118678, University Library of Munich, Germany.
    • Handle: RePEc:pra:mprapa:118678
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    References listed on IDEAS

    as
    1. Michael Johannes & Suresh Sundaresan, 2007. "The Impact of Collateralization on Swap Rates," Journal of Finance, American Finance Association, vol. 62(1), pages 383-410, February.
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    3. Ottonello, Pablo & Perez, Diego J. & Varraso, Paolo, 2022. "Are collateral-constraint models ready for macroprudential policy design?," Journal of International Economics, Elsevier, vol. 139(C).
    4. Sanjiv R. Das & Darrell Duffie & Nikunj Kapadia & Leandro Saita, 2007. "Common Failings: How Corporate Defaults Are Correlated," Journal of Finance, American Finance Association, vol. 62(1), pages 93-117, February.
    5. Pierre Collin‐Dufresne & Bruno Solnik, 2001. "On the Term Structure of Default Premia in the Swap and LIBOR Markets," Journal of Finance, American Finance Association, vol. 56(3), pages 1095-1115, June.
    6. Longstaff, Francis A & Schwartz, Eduardo S, 2001. "Valuing American Options by Simulation: A Simple Least-Squares Approach," University of California at Los Angeles, Anderson Graduate School of Management qt43n1k4jb, Anderson Graduate School of Management, UCLA.
    7. Longstaff, Francis A & Schwartz, Eduardo S, 2001. "Valuing American Options by Simulation: A Simple Least-Squares Approach," The Review of Financial Studies, Society for Financial Studies, vol. 14(1), pages 113-147.
    8. Arora, Navneet & Gandhi, Priyank & Longstaff, Francis A., 2012. "Counterparty credit risk and the credit default swap market," Journal of Financial Economics, Elsevier, vol. 103(2), pages 280-293.
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    Full references (including those not matched with items on IDEAS)

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    More about this item

    Keywords

    collateralization; collateral posting; credit support annex; credit risk modeling; the plumbing of financial system; derivatives valuation subject to credit risk.;
    All these keywords.

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G17 - Financial Economics - - General Financial Markets - - - Financial Forecasting and Simulation
    • G24 - Financial Economics - - Financial Institutions and Services - - - Investment Banking; Venture Capital; Brokerage
    • O11 - Economic Development, Innovation, Technological Change, and Growth - - Economic Development - - - Macroeconomic Analyses of Economic Development
    • O16 - Economic Development, Innovation, Technological Change, and Growth - - Economic Development - - - Financial Markets; Saving and Capital Investment; Corporate Finance and Governance

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