Collateral Posting and Choice of Collateral Currency -Implications for Derivative Pricing and Risk Management-

Masaaki Fujii, Yasufumi Shimada and Akihiko Takahashi
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Masaaki Fujii: Graduate School of Economics, University of Tokyo
Yasufumi Shimada: Capital Markets Division, Shinsei Bank, Limited
Akihiko Takahashi: Faculty of Economics, University of Tokyo

No CARF-F-216, CARF F-Series from Center for Advanced Research in Finance, Faculty of Economics, The University of Tokyo

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.

Pages: 21 pages
Date: 2010-05
New Economics Papers: this item is included in nep-ban, nep-fmk and nep-rmg
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Citations: View citations in EconPapers (3)

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Persistent link: https://EconPapers.repec.org/RePEc:cfi:fseres:cf216

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