The Impact of Collateralization on Derivative Valuation

This paper presents a model for pricing derivatives under collateral posting. Empirically, we find that counterparty risk and collateralization together have high explanatory power on premium spreads. The finding leads to practical implications, such as collateralization modeling allows forecasting credit spread. We also find that credit risk is negatively correlated with collateralization as an increase in collateralization causes a decrease in credit risk. The empirical tests corroborate our theoretical conclusions that collateralization can reduce CVA charges and mitigate counterparty risk.