Risk Allocation: The Double Face of Financial Derivatives

22 Pages Posted: 24 May 2011 Last revised: 13 Jul 2011

See all articles by Fulvio Corsi

Fulvio Corsi

University of Pisa - Department of Economics; City University London

Hykel Hosni

University of Milan - Department of Philosophy

Stefano Marmi

Scuola Normale Superiore

Date Written: july 12, 2011

Abstract

For the past two decades, derivatives provided the core financial innovation for risk- management and risk-sharing activities. However, in the aftermath of the 2007-2008 crisis, derivatives have started received, partly for good reason, an increasingly bad press. The main purpose of this paper is to lay the foundations for a theoretical frame-work in which systemic risk is centrally involved in the assessment of derivative usage. We begin by introducing a definition of systemic risk based on a Mixed Binomial model for the number of defaults. Then, we define an allocation to be efficient if it maximizes the Aggregate Sharpe ratio of the economy, i.e. if it allows to finance the maximum amount of productive investments while minimizing the overall systemic risk of the economy. We then say that a derivative is socially efficient or cooperative if it leads to an allocation having higher Aggregate Sharpe ratio. We illustrate the applicability of our model by means of a qualitative analysis of three types of derivatives, namely Plain vanilla, Asset backed securities and Credit default-swaps.

Keywords: systemic risk, derivatives, credit default swap

Suggested Citation

Corsi, Fulvio and Hosni, Hykel and Marmi, Stefano, Risk Allocation: The Double Face of Financial Derivatives (july 12, 2011). Available at SSRN: https://ssrn.com/abstract=1844288 or http://dx.doi.org/10.2139/ssrn.1844288

Fulvio Corsi (Contact Author)

University of Pisa - Department of Economics ( email )

via Ridolfi 10
I-56100 Pisa, PI 56100
Italy

HOME PAGE: http://people.unipi.it/fulvio_corsi/

City University London ( email )

Northampton Square
London, EC1V OHB
United Kingdom

Hykel Hosni

University of Milan - Department of Philosophy ( email )

via festa del perdono 7
Milan, 7-20122
Italy

Stefano Marmi

Scuola Normale Superiore ( email )

Piazza dei Cavalieri, 7
Pisa, 56126
Italy
+39050509064 (Phone)
+39050563513 (Fax)

HOME PAGE: http://homepage.sns.it/marmi/

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