A new model for pricing collateralized derivatives

[DavidS]

This paper presents a new model for valuing collateralized derivatives. It allows for collateral arrangement 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 suggest that there are important interactions between market and credit risk. We show that market and credit risk are positively correlated, whereas the degree of collateralization is negatively correlated with them.

A New Model for Pricing Collateralized Financial Derivatives by Tim Xiao :: SSRN