SENSITIVITIES AND HEDGING OF THE COLLATERAL CHOICE OPTION

Griselda Deelstra (), Lech A. Grzelak () and Felix L. Wolf
Additional contact information
Griselda Deelstra: Department of Mathematics, Université libre de Bruxelles, Brussels, Belgium
Lech A. Grzelak: Mathematical Institut, Utrecht University and Rabobank Nederland, Utrecht, the Netherlands
Felix L. Wolf: Department of Mathematics, Université libre de Bruxelles, Brussels, Belgium

International Journal of Theoretical and Applied Finance (IJTAF), 2022, vol. 25, issue 06, 1-35

Abstract: The collateral choice option allows a collateral-posting party the opportunity to change the type of security in which the collateral is deposited. Due to nonzero collateral basis spreads, this optionality significantly impacts asset valuation. Because of the complexity of valuing the option, many practitioners resort to deterministic assumptions on the collateral rates. In this paper, we focus on a valuation model of the collateral choice option based on stochastic dynamics. Intrinsic differences in the resulting collateral choice option valuation and its implications for collateral management are presented. We obtain sensitivities of the collateral choice option price under both the deterministic and the stochastic model, and we show that the stochastic model attributes risks to all involved collateral currencies. Besides an inability to capture volatility effects, the deterministic model exhibits a digital structure in which only the cheapest-to-deliver currency influences the valuation at a given time. We further consider hedging an asset with the collateral choice option by a portfolio of domestic and foreign zero-coupon bonds that do not carry the collateral choice option. We propose static hedging strategies based on the crossing times of the deterministic model and based on variance-minimization under the stochastic model. We show how the weights of this model can be explicitly determined with the semi-analytical common factor approach and we show in numerical experiments that this strategy offers good hedging performance under minimized variance.

Keywords: Collateral choice option; cheapest-to-deliver collateral; currency spreads; CSA; minimal-variance hedging; static hedging (search for similar items in EconPapers)
Date: 2022
References: Add references at CitEc
Citations:

Downloads: (external link)
http://www.worldscientific.com/doi/abs/10.1142/S0219024922500273
Access to full text is restricted to subscribers

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:wsi:ijtafx:v:25:y:2022:i:06:n:s0219024922500273

Ordering information: This journal article can be ordered from

DOI: 10.1142/S0219024922500273

Access Statistics for this article

International Journal of Theoretical and Applied Finance (IJTAF) is currently edited by L P Hughston

More articles in International Journal of Theoretical and Applied Finance (IJTAF) from World Scientific Publishing Co. Pte. Ltd.
Bibliographic data for series maintained by Tai Tone Lim ().