Discounting collateral: Quants, derivatives, and the reconstruction of the ‘risk-free rate’ after the financial crisis

Research output: Contribution to journalArticlepeer-review

Abstract

Serving as a pledge against a future promise, collateral has traditionally been understood as a ‘back office’ technicality that reduces the risk of default. Yet in the wake of the 2008 financial crisis and the erosion of faith among market participants in the credit quality of large banks, collateral is playing an increasingly important epistemic role within finance, as an anchor that underpins the valuation of a growing number of financial instruments. This paper explores the increasing importance of collateral to the modelling practices used by ‘quants’ to value ‘over-the-counter’ interest rate derivatives since the 2008 financial crisis, and how the inclusion of collateral expertise into quants’ own modelling practices has affected these markets. This historical episode suggests that while the inclusion of collateral expertise into banks’ front office modelling practices has made banks’ pricing models less abstract and more aligned to the traditionally overlooked legal practices that underpin derivatives trading, it has also led to an explosion of complexity in the valuation of these instruments that now threatens the future existence of these markets.
Original languageEnglish
Pages (from-to)343-370
JournalEconomy and Society
Volume48
Issue number3
Early online date13 May 2019
DOIs
Publication statusPublished - 3 Jul 2019

Keywords

  • collateral
  • valuation practices
  • financial modelling
  • LIBOR
  • interest rate derivatives
  • financial crisis

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