The Effect of Mutualization and Collateralization on Credit Default Swaps Premium

Abstract

This paper examines the effect of collateralization and mutualization (of losses) on credit default swaps (CDS) premium in a context of high counterparty risk operating through an opaque derivatives market. This setup certainly makes clearing practices to affect the size of positions, recovery rate and premium. This model not only has the benefit of being realist to the light of causes and propagation of great recession but also to assessing clearing practices in a partial equilibrium. I closely follow contributions of Koeppl and Monnet, Koeppl, Acharya and Bisin and Stephens and Thompson. I show that premium is high when mutualization takes place as clearing policy; the new allocation is characterized by a high recovery rate and low risk premium as fully-insured contracts spread significantly relative to OTC markets. The risk premium ebbs as different type of default-fund calls flow into the clearinghouse. The aforementioned pushes down the premium, however it does not offset the upward effect stemming from the increasing recovery rate. Additionally, as literature suggests collateralization avoids default, premium is high and the value of the position (or recovery rate) increases. In these contracts the risk premium is low too. This research contributes to compress insurance pricing theory into a material that may be a critical input in large macroeconomic models.