The Price of Protection: Derivatives, Default Risk, and Margining

Abstract

By attaching collateral to a derivatives contract, margining supposedly reduces default risk. In this paper, we first develop a set of testable hypotheses about the effects of margining on banks' welfare, trading volume, and default risk in the context of a stylized banking sector equilibrium model. Subsequently, we test these hypotheses with a market simulation model. Capturing some of the main characteristics of derivatives markets, we identify situations where margining may increase banks' default risk while reducing their welfare and their aggregate trading volume. This is the case, in particular, when margin rates are high and collateral is scarce.

Keywords: derivative securities, default risk, collateral, margining, systemic risk

JEL Classification: G19, G21