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Choice of Collateral Currency

by Masaaki Fujii of the University of Tokyo, and
Akihiko Takahashi of the University of Tokyo

December 7, 2010

Abstract: Collateral has been used for a long time in the cash market and we have also experienced significant increase of its use as an important credit risk mitigation tool in the derivatives market for this decade. Despite its long history in the financial market, its importance for funding has been recognized relatively recently following the explosion of basis spreads in the crisis. This paper has demonstrated the impact of collateralization on derivatives pricing through its funding effects based on the actual data of swap markets. It has also shown the importance of the "choice" of collateral currency. In particular, when a contract allows multiple currencies as eligible collateral as well as its free replacement, the paper has found that the embedded "cheapest-to-deliver" option can be quite valuable and significantly change the fair value of a trade. The implications of these findings for risk management have been also discussed.

Keywords: swap, collateral, derivatives, Libor, currency, OIS, EONIA, Fed-Fund, CCS, basis, risk management, HJM, FX option, CSA, CVA, term structure.

Previously titled: Collateral Posting and Choice of Collateral Currency: Implications for derivative pricing and risk management

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