Optimal Collateralization with Bilateral Default Risk

54 Pages Posted: 4 Sep 2013

See all articles by Daniel Bauer

Daniel Bauer

University of Wisconsin-Madison

Enrico Biffis

Imperial College Business School

Luz R. Sotomayor

Georgia State University - Department of Risk Management and Insurance

Date Written: August 22, 2013

Abstract

We consider over-the-counter (OTC) transactions with bilateral default risk, and study the optimal design of the Credit Support Annex (CSA). In a setting where agents have access to a trading technology, default penalties and collateral costs arise endogenously as a result of foregone investment opportunities. We show how the optimal CSA trades off the costs of the collateralization procedure against the reduction in exposure to counter-party risk and expected default losses. The results are used to provide insights on the drivers of different collateral rules, including hedging motives, re-hypothecation of collateral, and close-out conventions. We show that standardized collateral rules can have a detrimental impact on risk sharing, which should be taken into account when assessing the merits of standardized vs. bespoke CSAs in non-centrally cleared OTC instruments.

Suggested Citation

Bauer, Daniel and Biffis, Enrico and Sotomayor, Luz Rocío, Optimal Collateralization with Bilateral Default Risk (August 22, 2013). Available at SSRN: https://ssrn.com/abstract=2320108 or http://dx.doi.org/10.2139/ssrn.2320108

Daniel Bauer

University of Wisconsin-Madison ( email )

975 University Avenue
Madison, WI 53706
United States

Enrico Biffis (Contact Author)

Imperial College Business School ( email )

Imperial College London
South Kensington campus
London, SW7 2AZ
United Kingdom

Luz Rocío Sotomayor

Georgia State University - Department of Risk Management and Insurance ( email )

35 Broad Street
P.O. Box 4036
Atlanta, GA 30302-4036
United States
404-4137470 (Phone)
404-4137499 (Fax)

HOME PAGE: http://www.rmi.gsu.edu

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