TITLE:
The Role of Collateral in Credit Markets
AUTHORS:
Joseph Atta-Mensah
KEYWORDS:
Collateral, Credit, Credit Aggregates, Option Pricing, Risk Premium
JOURNAL NAME:
Journal of Mathematical Finance,
Vol.5 No.4,
November
5,
2015
ABSTRACT: The author examines the role of collateral in an environment where lenders and borrowers possess identical information and similar beliefs about its future value. Using option-pricing techniques, he shows that a secured loan contract is equivalent to a regular bond and an embedded option to the borrower to default. The author finds that the lender will not advance to the borrower, a loan that exceeds the market value of the collateral, and that the supply of loans increases with a rise in the market value of the collateral. Increases in the volatility of the value of the collateral, interest rate, and dividend rate of the collateral independently depress the loan supply. The author also derives the cost of a third-party guarantee of a loan and an implied risk premium.