Munich Personal RePEc Archive

Modeling Collateralization and Its Economic Significance

Lee, David (2023): Modeling Collateralization and Its Economic Significance.

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ABSTRACT This article presents a new model of collateralization. We study the economic impact of collateralization on the plumbing of the financial system. The model gives an integrated view of different collateral arrangements. We show that the effect of collateral on asset prices is significant. Our study shows that a poorly designed collateral agreement can actually increase credit risk. We find evidence that collateral posting regimes that are originally designed and utilized for contracts subject to bilateral credit risk (e.g., a swap) may not work properly for contracts subject to multilateral credit risk (e.g., a CDS) in the presence of default correlations. These findings contradict the prevailing beliefs in financial markets about collateralization.

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