Wednesday, May 19, 2010

Collateral Posting and Choice of Collateral Currency: Implications for derivative pricing and risk management

by Masaaki Fujii, Yasufumi Shimada, and Akihiko Takahashi

Abstract: In recent years, we have observed the dramatic increase of the use of collateral as an important credit risk mitigation tool. It has become even rare to make a contract without collateral agreement among the major financial institutions. In addition to the significant reduction of the counterparty exposure, collateralization has important implications for the pricing of derivatives through the change of effective funding cost. This paper has demonstrated the impact of collateralization on the derivative pricing by constructing the term structure of swap rates based on the actual market data. It has also shown the importance of the "choice" of collateral currency. Especially, when the contract allows multiple currencies as eligible collateral and free replacement among them, the paper has found that the embedded "cheapest-to-deliver" option can be quite valuable and significantly change the fair value of a trade. The implications of these findings for market risk management have been also discussed.

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