Abstract
In this study, we propose a microeconomics model to verify effects of the non-cash collateralization on the liquidity of the over-the-counter (OTC) derivatives markets accepting both cash and non-cash assets. Liquidity is measured as an equilibrium volume of the derivatives contract. The equilibrium volume is obtained by solving the utility maximization problem of a risk-averse collateral payer who wants to optimize her/his capital. The collateral payer’s capital depends on the non-cash asset used as collateral. We consider both option and forward contracts as examples. Our sensitivity analysis shows that the optimal combination of cash and non-cash collaterals can maximize the liquidity of derivatives. Especially for option contracts, the market requires both cash and non-cash collaterals for liquidity. The empirical result related to this finding is provided. Overall, the introduction of non-cash collateralization boosts the liquidity of derivatives contracts. We also show how the arrangements of collateralization can boost the liquidity of the OTC derivatives markets. Moreover, we demonstrate that the combination of cash and non-cash collaterals to maximize liquidity differs from that to maximize the participant’s utility. This indicates that the optimal combination is not efficient in terms of Pareto criteria.
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Notes
Nikkei Asian Review, Exchanges Compete for Dominance in Derivatives, April 25, 2017 (https://asia.nikkei.com/Business/Banking-Finance/).
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Funding
Funding was provided by Japan Society for the Promotion of Science (Grant no. 17K18219).
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This work was supported by JSPS KAKENHI Grant Number 17K18219. We would like to appreciate participants at the 95th Mathematical Modeling and Data Science seminar, Finance and Insurance seminar series (Osaka University), and an anonymous reviewer of Review of Derivatives Research for helpful comments.
Appendices
Motivation from technical viewpoint
In this section, we provide a brief discussion of the motivation for this study from the perspective of the participant with a negative exposure (i.e., the bank).
At the contract date \(t_n\), the bank enters \(k_{t_n}\) units of the derivatives contract with a negative exposure. Then, the bank has to post collateral with cash or bond or both and receives the derivatives value \(k_{t_n}|V_{t_n}|\) from the dealer. The cash received from the dealer is used as cash collateral. Then, the amount of the cash collateral is \(\eta k_{t_n}|V_{t_n}|\), and that of the non-cash collateral is \(k_{t_n}\frac{1-\eta }{1-h}\frac{|V_{t_n}|}{B_{t_n}}B_{t_n}\) considering the haircut. The dealer, who is the collateral receiver, should pay interest (at the collateral rate) on the posted cash collateral whether a default occurs or not. We denote the cash account and value of the bond held by the bank at time t as \(A^C_t\) and \(A^B_t\), respectively. Then, the cash account and value of the bond held by the collateral payer at the contract date \(t_n\) are, respectively,
At the next MtM date \(t_{n+1}\), in case of no default, the bank recovers the posted collateral. The bank also earns interest on the cash collateral. In case of default, the bank does not recover the posted collateral at all. Then, the cash account and value of the bond held by the bank at the next MtM date \(t_{n+1}\) are, respectively,
where \(\tau \) is the default time of the bank. Therefore, the change in the asset amount of the collateral payer is
If the bank does not default (i.e., \(1_{\tau <t_{n+1}}=0\)), then (A.1) is
From (A.2), we have
if the effect of \(\eta \) on the value of \(V_{t_n}\) is negligibly small.
We interpret the relationship (A.3) as follows. The bank is willing to post the cash collateral (\(\eta \nearrow 1\)) if \(r^c>r\). However, when \(r>r^c\), the bank is willing to post the non-cash asset collateral (\(\eta \searrow 0\)). This means that the bank must choose either a cash or non-cash asset as collateral. Moreover, her/his decision depends on the levels of interest rates at the contract date \(t_n\) only. However, if the bank can default, we have
from (A.1). Therefore, we deduce that the bank’s collateral asset selection is more complicated when a default occurs because she/he should not only consider the levels of interest rates at the contract date but also should be concerned about the (stochastic) change in the bond price during \([t_n,t_{n+1}]\) unlike the no default case. Moreover, since the bank is risk-averse, it might avoid choosing only either cash or non-cash asset as collateral. In this study, we show how the collateral payer combines the collateral assets and then verify the validity of the recent clearinghouse actions.
Proof of Proposition 3.1
The dealer deposits the posted cash collateral \(\eta V_t\) with risk-free rate r and the returns with collateral rate \(r^c\). The dealer also sources cash \(\frac{1-h_p}{1-h}(1-\eta )V_t=(1-\eta )V_t\) (under the assumption \(h=h_p\)) by exchanging it for the posted bond worth \(\frac{1}{1-h}(1-\eta )V_t\) in the repo market. The money sourced via the repo market is further deposited with risk-free rate r, and the returns are deposited with the repo rate \(r^p\). Thus, the instantaneous change in collateral for the collateral receiver is
Therefore, when we denote the total collateral value at time t by \(C_t\), the derivatives’ time t value is given by
The first expectation shows that the derivatives payment included the net return from investing the posted collateral without defaults, and the second expectation shows that the collateral value included the net return from investing the posted collateral at default. Equation (B.1) agrees with (A.1) of Johannes and Sundaresan (2007). The assumption of continuous and perfect collateralization yields
for \(0\le t \le T\). Then, Eq. (B.1) reduces to
Several studies have derived the pricing equation for the contingent claim \(V_T\) with maturity T from (B.3) (Fujii et al. 2010; Fujii and Takahashi 2016; Johannes and Sundaresan 2007). We follow their derivations. Set
then
Hence, \(Z_t\) is a Q-martingale. From (B.4), it holds
By arranging (B.5), we have the (linear) backward stochastic differential equation,
By solving (B.6), we have the derivatives pricing formula under full collateralization,
Calculation of statistics
Each term of (3.5) is calculated as follows.
since \((1-1_{\tau<t_{n+1}})^2=1-1_{\tau <t_{n+1}}\), \((1_{\tau<t_{n+1}})^2=1_{\tau <t_{n+1}}\) and \((1-1_{\tau<t_{n+1}})\times 1_{\tau <t_{n+1}}=0\).
For the constant intensity process \(\lambda \) defined above, each term in (3.5) is calculated as follows.
Closed formula for collateralized option price
We derive a closed formula for the collateralized option price by following Kim (2002).
At first, under measure Q given by (4.1), each stochastic process is represented as
where \({\tilde{W}}=({\tilde{W}}_1,{\tilde{W}}_2,\ldots ,{\tilde{W}}_4)\) is a four-dimensional standard Brownian motion under measure Q.
We set
Then, for the dynamics introduced in Sect. 4.1, we have
Define
where
then \(Z_{s,T}\) is rewritten as
Since \({\tilde{W}}=({\tilde{W}}_1,{\tilde{W}}_2,{\tilde{W}}_3,{\tilde{W}}_4)\) is the four-dimensional standard Brownian motion, \(X_1\) and \(X_2\) respectively follow the normal distribution. Thus, \(X=(X_1,X_2)\) follows the two-dimensional normal distribution;
where the mean vector is \(\mu ^{s,t}\equiv (0,0)^\top \) (\(\forall t>s\)) and the covariance matrix is
At this point, the inequality of \(Z_{s,T}\ge 0\) is equivalent to
where
Therefore, the time-s price of collateralized option \(V_s\) with maturity T is given by
Terms (I) and (II) in (D.1) are solved as follows.
where x means \(x=(x_1,x_2)^\top \), \(\phi _2(\cdot |a,b)\) is the probability density function of the two-dimensional normal distribution with mean vector a and covariance matrix b, \(\Phi (\cdot )\) is the cumulative distribution function of the standard normal distribution,
and
From the forth line to the fifth line in (D.2), we used Lemma 1 in Kim (2002).
where
Closed formula for collateralized forward valuation
The time-s value \(V_s\) of the forward contract maturing at time T given the forward price \(F_B\) of \(B_T\) is solved as follows.
where \(M_j(s,T)\) and \(\Sigma _{jj}^{s,t}\) (\(j=1,2\)) are given in Appendix D.
Since the forward price \(F_B\) is given as a solution of
\(F_B\), therefore, is given by
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Takino, K. The impact of non-cash collateralization on the over-the-counter derivatives markets. Rev Deriv Res 25, 137–171 (2022). https://doi.org/10.1007/s11147-021-09184-6
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DOI: https://doi.org/10.1007/s11147-021-09184-6