Optimal Collateralization with Bilateral Default Risk by Daniel Bauer

Event Date: 

Monday, April 11, 2016 - 3:30pm to 5:00pm

Event Date Details: 

Refreshments served at 3:15 p.m

Event Location: 

  • South Hall 5607F

Daniel Bauer — Georgia State University

Title: Optimal Collateralization with Bilateral Default Risk

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 collateralization against the reduction in exposure to counterparty risk. 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. customized CSAs in bilateral OTC Transactions. (joint work with Enrico Biffis and Luz Rocio Sotomayor)