A Derivatives Pricing Model with Non-Cash Collateralization

This article proposes a derivatives pricing model with both cash and a non-cash asset posted as collateral for a derivatives contract. We assume that the participant sources funds from the repo market for the posted non-cash collateral. Our pricing formula is based on the investment of the received collaterals. For the pricing formula, we discount the future derivatives value using a combination of the collateral and repo rates under a risk-neutral measure. Thus, our pricing model constructs a multi-curve framework. We calibrate our pricing model for JPY interest rate derivatives and then show that our model with non-cash collateralization is closer to the real price than the existing pricing formulae (i.e., the cash collateralization and simple short rate models).