Rehypothecation Dilemma: Impact of Collateral Rehypothecation on Derivative Prices Under Bilateral Counterparty Credit Risk

33 Pages Posted: 28 Aug 2012 Last revised: 29 Oct 2013

See all articles by Yuji Sakurai

Yuji Sakurai

Federal Reserve Banks - Federal Reserve Bank of Richmond

Yoshihiko Uchida

Bank of Japan - Institute for Monetary and Economic Studies

Date Written: August 19, 2013

Abstract

Rehypothecation is the practice where a derivatives dealer reuses collateral posted from its end user in over-the-counter (OTC) derivatives markets. Although rehypothecation benefits the end user through cost reduction of derivative trades, it also creates additional counterparty credit risk since the end user may not receive the collateral back when the dealer suddenly defaults. To evaluate the benefits and risks of rehypothecation, we propose a derivative pricing framework with bilateral counterparty credit risk that determines the amount of rehypothecable collateral. We also model the realistic features of derivative trades: two different types of collateral, the time delay of collateral posting and the rating-dependent collateral agreement. We apply our pricing framework to cross currency swaps and investigate the impact of rehypothecation on the swap spreads.

Keywords: shadow banking, collateral segregation, credit rating migration, margin call

JEL Classification: G13, G32, G33

Suggested Citation

Sakurai, Yuji and Uchida, Yoshihiko, Rehypothecation Dilemma: Impact of Collateral Rehypothecation on Derivative Prices Under Bilateral Counterparty Credit Risk (August 19, 2013). 25th Australasian Finance and Banking Conference 2012, Available at SSRN: https://ssrn.com/abstract=2136785 or http://dx.doi.org/10.2139/ssrn.2136785

Yuji Sakurai (Contact Author)

Federal Reserve Banks - Federal Reserve Bank of Richmond ( email )

P.O. Box 27622
Richmond, VA 23261
United States

Yoshihiko Uchida

Bank of Japan - Institute for Monetary and Economic Studies ( email )

2-1-1, Hongoku-cho
Nihonbashi
Chuo-ku, Tokyo, 103
Japan

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