Managing Counterparty Risk in OTC Markets

42 Pages Posted: 7 Sep 2017 Last revised: 29 Apr 2020

See all articles by Christoph Frei

Christoph Frei

University of Alberta - Department of Mathematical and Statistical Sciences

Agostino Capponi

Columbia University

Celso Brunetti

Board of Governors of the Federal Reserve System

Date Written: 2017-08-15

Abstract

We study how banks manage their default risk to optimally negotiate quantities and prices of contracts in over-the-counter markets. We show that costly actions exerted by banks to reduce their default probabilities are inefficient. Negative externalities due to counterparty concentration may lead banks to reduce their default probabilities even below the social optimum. The model provides new implications which are supported by empirical evidence: (i) intermediation is done by low-risk banks with medium initial exposure; (ii) the risk-sharing capacity of the market is impaired, even when the trade size limit is not binding; and (iii) intermediaries play the fundamental role of diversifying the idiosyncratic risk in CDS contracts, besides increasing the risk-sharing capacity of the market.

Keywords: Over-the-counter markets, Conterparty concentration, Counterparty risk, Negative externalities

JEL Classification: G11, G12, G21

Suggested Citation

Frei, Christoph and Capponi, Agostino and Brunetti, Celso, Managing Counterparty Risk in OTC Markets (2017-08-15). FEDS Working Paper No. 2017-083, Available at SSRN: https://ssrn.com/abstract=3029733 or http://dx.doi.org/10.17016/FEDS.2017.083r1

Christoph Frei (Contact Author)

University of Alberta - Department of Mathematical and Statistical Sciences ( email )

Edmonton, Alberta T6G 2G1
Canada
+1 780 492 3613 (Phone)

HOME PAGE: http://www.math.ualberta.ca/~cfrei/

Agostino Capponi

Columbia University ( email )

S. W. Mudd Building
New York, NY 10027
United States

Celso Brunetti

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

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