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A New Model for Pricing Collateralized Financial Derivatives

In recent years, collateralization of derivative contracts has extended from the standard mark-to-market and margining systems for exchange-traded contracts to the over-the-counter (OTC) market. This expansion of credit enhancement in OTC contracts has been underway at least since the 1990s, but it was formalized in the Dodd–Frank Act. The great majority of derivatives are now subject to collateralization requirements that are specified in a Credit Support Annex to the counterparties’ ISDA agreement. Derivatives counterparties must make a credit value adjustment (CVA) to the value of a contract on their books to account for the effect of counterparty credit risk. But the pricing models generally do not take the interaction between market prices and collateral values into account. This article develops a valuation approach that incorporates the counterparty’s credit quality and the effect of collateral, given market practices on how collateral is handled both under normal conditions and in a bankruptcy. Empirical comparison of the pricing of matched swaps with and without collateral support shows that the market does adjust for the mitigation of counterparty risk by the use of collateral, and that both factors are important.