Systemic Failure in a Network of Derivative Contracts

Abstract

This paper studies how systemic risk can appear when rational agents establish derivative contracts in a fixed network. Agents are endowed with risks. They optimize their situation by designing and trading derivative contracts. Those deals spread the risks throughout the network and harmonize the amount of capital agents tie up respectively to their exposure. This leads to the emergence of a tipping point of systemic failure. Only the agents who made benefits from the trades can survive past this tipping point. When taking into account the contagion of failures, survivors quickly default as well. This occurs for a large class of networks and behaviors.

Keywords: Systemic Risk, Default Contagion, Financial Networks, Financial Crisis, Risk Measures

JEL Classification: C63, D85, G21, G32, L14