Collateral Agreement and Derivatives market

This paper studies the impact of collateral agreement on derivatives pricing and credit risk in financial markets. A new model is being developed for derivatives valuation with collateral posting. The model allows us to decompose market prices into credit risk factors. We derive an upper bound on the collateral threshold. If the real collateral threshold is less than this upper bound, the collateral arrangement can improve default recovery and mitigate credit risk as intended. If the real collateral threshold exceeds this upper bound, the collateral arrangement can deteriorate default recovery and aggravate credit risk. These results further emphasize the importance of carefully designing collateral arrangements.