The author examines the role of collateral in an environment where lenders and borrowers possess identical information and similar beliefs about its future value. Using option-pricing techniques, he shows that a secured loan contract is equivalent to a regular bond and an embedded option to the borrower to default. The author finds that the lender will not advance to the borrower, a loan that exceeds the market value of the collateral, and that the supply of loans increases with a rise in the market value of the collateral. Increases in the volatility of the value of the collateral, interest rate, and dividend rate of the collateral independently depress the loan supply. The author also derives the cost of a third-party guarantee of a loan and an implied risk premium.
Cite this paper
Atta-Mensah, J. (2015) The Role of Collateral in Credit Markets. Journal of Mathematical Finance
, 315-327. doi: 10.4236/jmf.2015.54027
 Coco, G. (2000) On the Use of Collateral. Journal of Economic Surveys, 14, 191-214. http://dx.doi.org/10.1111/1467-6419.00109
 Black, J., de Meza, D. and Jeffreys, D. (1996) House Prices, the Supply of Collateral and the Enterprise Economy. The Economic Journal, 106, 60-75. http://dx.doi.org/10.2307/2234931
 Leeth, J. and Scott, J. (1989) The Incidence of Secured Debt: Evidence from the Small Business Community. Journal of Financial and Quantitative Analysis, 24, 379-394. http://dx.doi.org/10.2307/2330818
 Berger, A. and Udell, G. (1990) Collateral, Loan Equity, and Bank Risk. Journal of Monetary Economics, 25, 21-42. http://dx.doi.org/10.1016/0304-3932(90)90042-3
 Bester, H. (1985) Screening vs. Rationing in Credit Markets with Imperfect Information. American Economic Review, 75, 850-855.
 Besanko, D. and Thakor, A. (1987) Competitive Equilibrium in the Credit Market under Asymmetric Information. Journal of Economic Theory, 42, 167-182.http://dx.doi.org/10.1016/0022-0531(87)90108-6
 Chan, Y. and Kanatas, G. (1985) Asymmetric Valuation and the Role of Collateral in Loan Agreements. Journal of Money, Credit and Banking, 17, 84-95. http://dx.doi.org/10.2307/1992508
 Bester, H. (1994) The Role of Collateral in a Model of Debt Renegotiation. Journal of Money, Credit and Banking, 26, 72-86.http://dx.doi.org/10.2307/2078035
 Barro, R. (1976) The Loan Market, Collateral and Rate of Interest. Journal of Money, Credit and Banking, 8, 839-856. http://dx.doi.org/10.2307/1991690
 Atta-Mensah, J. (1992) The Valuation of Commodity-Linked Bonds. Unpublished PhD Thesis, Simon Fraser University.
 Merton, R. (1973) The Theory of Rational Option Pricing. Bell Journal of Economics and Management Science, 4, 141-183. http://dx.doi.org/10.2307/3003143
 Geske, R. (1979) The Valuation of Compound Options. Journal of Financial Economics, 7, 63-81. http://dx.doi.org/10.1016/0304-405X(79)90022-9
 Merton, R. (1977) An Analytical Derivation of the Cost of Deposit Insurance and Loan Guarantees: An Application of Modern Option Pricing Theory. Journal of Banking and Finance, 1, 3-11. http://dx.doi.org/10.1016/0378-4266(77)90015-2