Systemic Risk in Off-Exchange Derivatives Markets
Posted: 14 Sep 1999
Date Written: July 1994
Many government officials, regulators and others have described scenarios whereby the failure of an intermediary in the swap market causes other intermediaries to fail in a "domino"-like effect, with potentially significant adverse systemic consequences. While the ultimate domino-effect scenario is indeed a dire one, the collateral impact that correlated failures of even some participants might have on the financial system is also of concern. Thus, this paper deals with correlated bankruptcies of intermediaries, or systemic risk; to date, no careful analysis of this problem has appeared.This document describes a model that, while a simplification of the realities of the actual swap market, nevertheless is rich enough to capture the important stylized elements of that market. The model incorporates: varying hedging horizons for counterparties; interdealer hedging by intermediaries (possibly with futures); diversification by intermediaries; both systematic and idiosyncratic risk; and changes to counterparty hedging needs. This model allows us to investigate the probability of correlated bankruptcies of intermediaries, i.e., systemic risk. The ability to obtain closed-form solutions for these probabilities is an especially beneficial result.
JEL Classification: G1
Suggested Citation: Suggested Citation