Risk protection from risky collateral: Evidence from the euro bond market

This paper studies empirically how collateral protects the market value of defaultable bonds from changes in risk. We construct a measure of the risk protection from collateral, and estimate it under different economic conditions. Using yields from the euro bond market, we find that the risk protection from collateral is conditional, significantly stronger in both general and issuer-specific bad states. However, the collateral is risky, and a fall in the collateral value clearly lowers the risk protection. Consequently, the correlation between the bad state and the collateral value is crucial when assessing the risk reducing properties of collateral.