Share This Article:

The Role of Collateral in Credit Markets

Full-Text HTML XML Download Download as PDF (Size:320KB) PP. 315-327
DOI: 10.4236/jmf.2015.54027    2,250 Downloads   2,841 Views  


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.

Conflicts of Interest

The authors declare no conflicts of interest.

Cite this paper

Atta-Mensah, J. (2015) The Role of Collateral in Credit Markets. Journal of Mathematical Finance, 5, 315-327. doi: 10.4236/jmf.2015.54027.


[1] Coco, G. (2000) On the Use of Collateral. Journal of Economic Surveys, 14, 191-214.
[2] 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.
[3] 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.
[4] Berger, A. and Udell, G. (1990) Collateral, Loan Equity, and Bank Risk. Journal of Monetary Economics, 25, 21-42.
[5] Bester, H. (1985) Screening vs. Rationing in Credit Markets with Imperfect Information. American Economic Review, 75, 850-855.
[6] Besanko, D. and Thakor, A. (1987) Competitive Equilibrium in the Credit Market under Asymmetric Information. Journal of Economic Theory, 42, 167-182.
[7] 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.
[8] Bester, H. (1994) The Role of Collateral in a Model of Debt Renegotiation. Journal of Money, Credit and Banking, 26, 72-86.
[9] Barro, R. (1976) The Loan Market, Collateral and Rate of Interest. Journal of Money, Credit and Banking, 8, 839-856.
[10] Atta-Mensah, J. (1992) The Valuation of Commodity-Linked Bonds. Unpublished PhD Thesis, Simon Fraser University.
[11] Merton, R. (1973) The Theory of Rational Option Pricing. Bell Journal of Economics and Management Science, 4, 141-183.
[12] Geske, R. (1979) The Valuation of Compound Options. Journal of Financial Economics, 7, 63-81.
[13] 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.

comments powered by Disqus

Copyright © 2018 by authors and Scientific Research Publishing Inc.

Creative Commons License

This work and the related PDF file are licensed under a Creative Commons Attribution 4.0 International License.