Essays on the effect of clearing practices on swap rates
Creators: name: Rojas Cama, Freddy
Publisher: name: No Publisher Supplied
Year: 2018

description: This dissertation contributes to understand the interplay between price of derivatives and clearinghouses; the following chapters intend to overcome especific gaps in the literature since the effect of clearing practices is still not well understood in literature. In the first chapter I study the relationship between the price of derivatives and clearing practices in a theoretical framework. Specifically, I setup this connection by measuring the total exposure (the loss upon default of a contract) registered in a clearinghouse and its respective amount of collateral requirement. I find that netting through novation has significant gains in reducing exposures and therefore making a clearinghouse more competitive in terms of prices and collateral requirements thus clearing turns out to be appealing to more participants. Additionally, I also find above gains are large when comparing a financial structure of one clearinghouse respect to other with two specialized clearinghouses. In the case of interest rate swaps I find a relationship between netting and the Libor rate that may potentially affect the difference in prices among clearinghouses; in other words, a linear correlation calculated over time-series data and term structure seems to validate the appearance of a widening basis -a price differential- between London Clearing House and Chicago Mercantile Exchange. In the second chapter I show statistical evidence of a negative and significant impact of clearing practices on price of derivatives. This empirical finding supports the theoretical model discussed in Cama (2017) which provides a method for swap valuation that hinges on the size of the exposure in a clearing arrangement; the foregoing is particularly clear when the clearing practices strengthen. In practice, hedging exposures and performing risk management (through collateralization) introduce multilateral netting, compression and other clearing procedures. These practices eventually would affect the price of contracts making possible the observation of a significant wedge in the pricing of derivatives amid markets. I consider the cases of interest rate and credit default swaps for the quantitative assessment. I found that the basis (difference of swap rates between clearinghouses) has a higher persistence and its variance may be large when market participation increases, the former -as discussed in the chapter- is a sign of eventual deepening clearing practices. The regression analysis supports previous findings and show that bias is not significant larger when variables measuring additional characteristics of contracts are omitted due to access-to-data issues. In the third chapter I investigate the effects of collateralization and mutualization on credit default swaps (CDS) premium in a context of high counterparty risk operating through an opaque derivatives market. Literature mostly analyzes clearing in exchange markets and assumes that terms of trade are invariant to policies. My approach certainly makes clearing practices to affect the size of positions, recovery rate and premium. I study the interplay between clearing practices and pricing of the asset in a theoretical framework that allows excessive leverage of short positions. This environment not only has the benefit of being realist to the light of causes and propagation of great recession but also to assess clearing practices in a partial equilibrium. I closely follow contributions of Koeppl and Monnett (2010), Koeppl (2013), Acharya and Bisin (2014) and Stephens and Thompson (2011). I show the premium is low when mutualization takes place as clearing policy; specially when capital requirement ratio is substantially manageable. The allocation is characterized by high recovery rate and non-defaulting contracts spread significantly relative to a bilateral agreement. On the other hand, as literature suggests collateral avoids detrimental outcomes; premium is higher under collateralization practices since the value of the position (or recovery rate) increases. Existent empirical literature finds mixed results after controlling for liquidity and dealer networking. This chapter provides answers to this oxymoron. This research contributes to compress the asset pricing theory into a material that would be critical as input in large macroeconomic models.