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Collateralization Examination The reason collateralization of financial derivatives and repos has become one of the most important and widespread credit risk mitigation techniques is that the Bankruptcy Code contains a series of “safe harbor” provisions to exempt these contracts from the “automatic stay”. The automatic stay prohibits the creditors from undertaking any act that threatens the debtor’s asset, while the safe harbor, a luxury, permits the creditors to terminate derivative and repo contracts with the debtor in bankruptcy and to seize the underlying collateral. This paper focuses on safe harbor contracts (e.g., derivatives and repos), but many of the points made are equally applicable to automatic stay contracts. There are three types of collateralization: full, partial or over. Full-collateralization is a process where the posting of collateral is equal to the current mark-to-market (MTM) value. Partial/under-collateralization is a process where the posting of collateral is less than the current MTM value. Over-collateralization is a process where the posting of collateral is greater than the current MTM value. From the perspective of collateral obligations, collateral arrangements can be unilateral or bilateral. In a unilateral arrangement, only one predefined counterparty has the right to call for collateral. Unilateral agreements are generally used when the other counterparty is much less creditworthy. In a bilateral arrangement, on the other hand, both counterparties have the right to call for collateral. Upon default and early termination, the values due under the ISDA Master Agreement are determined. These amounts are then netted and a single net payment is made. All of the collateral on hand would be available to satisfy this total amount, up to the full value of that collateral. In other words, the collateral to be posted is calculated on the basis of the aggregated value of the portfolio, but not on the basis of any individual transaction. The use of collateral in financial markets has increased sharply over the past decade, yet analytical and empirical research on collateralization is relatively sparse. The effect of collateralization on financial contracts is an understudied area. Collateral management is often carried out in an ad-hoc manner, without reference to an analytical framework. Comparatively little research has been done to analytically and empirically assess the economic significance and implications of collateralization. Such a quantitative and empirical analysis is the primary contribution of this paper. Due to the complexity of quantifying collateralization, previous studies seem to turn away from direct and detailed modeling of collateralization (see Fuijii and Takahahsi (2012)). For example, Johannes and Sundaresan (2007), and Fuijii and Takahahsi (2012) characterize collateralization via a cost-of-collateral instantaneous rate (or stochastic dividend or convenience yield). Piterbarg (2010) regards collateral as a regular asset in a portfolio and uses the replication approach to price collateralized contracts. All of the previous works focus on full-collateralization only. In contrast to other collateralization models in current literature, we characterize a collateral process directly based on the fundamental principal and legal structure of the CSA agreement. A model is devised that allows for collateralization adhering to bankruptcy laws. As such, the model can back out differences in prices due to counterparty risk. This framework is very useful for valuing off-the-run or outstanding financial contracts subject to credit risk and collateralization, where the price quotes are not available. Given this model, we are able to explain credit-related spreads and provide an important tool for credit value adjustment (CVA). Our theoretical analysis shows that collateralization can always improve recovery and reduce credit risk. If a contract is over-collateralized (e.g., a repo or cleared contract), its value is equal to the risk-free value. If a contract is partially collateralized (e.g., an OTC derivatives), its CSA value is less than the risk-free value but greater than the non-CSA risky value. Second, how can the model be empirically verified? To achieve the verification goal, this paper empirically measures the effect of collateralization on pricing and compares it with model-implied prices. This calls for data on financial contracts that have different collateral arrangements but are similar otherwise. We use a unique interest rate swap contract data set from an investment bank for the empirical study, as interest rate swaps collectively account for around two-thirds of both the notional and market value of all outstanding derivatives. Prior research has primarily focused on the generic mid-market swap rates and results appear puzzling. Sorensen and Bollier (1994) believe that swap spreads (i.e., the difference between swap rates and par yields on similar maturity Treasuries) are partially determined by counterparty default risk. Whereas Duffie and Huang (1996), Hentschel and Smith (1997), Minton (1997) and Grinblatt (2001) find weak or no evidence of the impact of counterparty credit risk on swap spreads. Collin-Dufresne and Solnik (2001) and He (2001) further argue that many credit enhancement devices, e.g., collateralization, have essentially rendered swap contracts risk-free. Meanwhile, Duffie and Singleton (1997), and Liu, Longstaff and Mandell (2006) conclude that both credit and liquidity risks have an impact on swap spreads. Moreover, Feldhütter and Lando (2008) find that the liquidity factor is the largest component of swap spreads. It seems that there is no clear-cut answer yet regarding the relative contribution of the liquidity and credit factors. Maybe, the recently revealed LIBOR scandal can partially explain these conflicting findings. Although the practice recommended by CCPs is popular in the market, in which derivatives are continuously negotiated over-the-counter as usual but cleared and settled through clearinghouses, some market participants cast doubt on CCPs’ economic equivalence claim. They find that cleared contracts have actually significant differences when compared with OTC trades. Some firms even file legal action against the learinghouses, and accuse them of fraudulently inducing the firms to enter into cleared derivatives on the premise the contracts would be economically equivalent to OTC contracts (see Pengelly (2011)). Collateralization examination |