Contagion in Derivatives Markets

37 Pages Posted: 6 Dec 2016 Last revised: 18 Jan 2018

See all articles by Mark E. Paddrik

Mark E. Paddrik

Government of the United States of America - Office of Financial Research

Sriram Rajan

Government of the United States of America - Office of Financial Research

Peyton Young

Government of the United States of America - Office of Financial Research; Brookings Institution; University of Oxford

Date Written: January 5, 2018

Abstract

A major credit shock can induce large intra-day variation margin payments between counterparties in derivatives markets, which may force some participants to default on their payments. These payment shortfalls become amplified as they cascade through the network of exposures. Using detailed DTCC data we model the full network of exposures, the shock-induced payments, the initial margin collected, and liquidity buffers for about 900 firms operating in the U.S. credit default swaps market. We estimate the total amount of contagion, the marginal contribution of each rm to contagion, and the number of defaulting firms for credit shocks of different magnitudes. A novel feature of the model is that it allows for a range of possible responses to balance sheet stress, including delayed or partial payments. These 'soft default' options distinguish our approach from conventional network models, which typically assume that full default is triggered whenever the default boundary is breached.

Keywords: Credit default swaps, stress testing, systemic risk, financial networks

JEL Classification: D85, G01, G17, L14

Suggested Citation

Paddrik, Mark Endel and Rajan, Sriram and Young, Peyton, Contagion in Derivatives Markets (January 5, 2018). OFR WP 16-12, Available at SSRN: https://ssrn.com/abstract=2880927 or http://dx.doi.org/10.2139/ssrn.2880927

Mark Endel Paddrik (Contact Author)

Government of the United States of America - Office of Financial Research ( email )

717 14th Street, NW
Washington DC, DC 20005
United States

Sriram Rajan

Government of the United States of America - Office of Financial Research ( email )

717 14th Street, NW
Washington DC, DC 20005
United States

Peyton Young

Government of the United States of America - Office of Financial Research ( email )

717 14th Street, NW
Washington DC, DC 20005
United States

Brookings Institution

1775 Massachusetts Ave, NW
Washington, DC 20036
United States

University of Oxford

Mansfield Road
Oxford, Oxfordshire OX1 4AU
United Kingdom

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