  This paper presents a new model for pricing financial derivatives subject to
collateralization. It allows for collateral arrangements adhering to bankruptcy
laws. As such, the model can back out the market price of a collateralized
contract. This framework is very useful for valuing outstanding derivatives.
Using a unique dataset, we find empirical evidence that credit risk alone is
not overly important in determining credit-related spreads. Only accounting for
both collateral posting and credit risk can sufficiently explain unsecured
credit costs. This finding suggests that failure to properly account for
collateralization may result in significant mispricing of derivatives. We also
empirically gauge the impact of collateral agreements on risk measurements. Our
findings indicate that there are important interactions between market and
credit risk.
