Rehypothecation Dilemma: Impact of Collateral Rehypothecation on Derivative Prices Under Bilateral Counterparty Credit Risk

Abstract

Rehypothecation is the practice where a derivatives dealer reuses collateral posted from its end user in over-the-counter (OTC) derivatives markets. Although rehypothecation benefits the end user through cost reduction of derivative trades, it also creates additional counterparty credit risk since the end user may not receive the collateral back when the dealer suddenly defaults. To evaluate the benefits and risks of rehypothecation, we propose a derivative pricing framework with bilateral counterparty credit risk that determines the amount of rehypothecable collateral. We also model the realistic features of derivative trades: two different types of collateral, the time delay of collateral posting and the rating-dependent collateral agreement. We apply our pricing framework to cross currency swaps and investigate the impact of rehypothecation on the swap spreads.