Risks in Derivatives Markets

WFIC 96-24

Posted: 16 Jun 1998

See all articles by Ludger Hentschel

Ludger Hentschel

Alternative Risk Premia Investments

Clifford W. Smith

Simon Graduate School of Business, University of Rochester

Date Written: November 20, 1995

Abstract

The debate over risks and regulation in derivatives markets has failed to provide a clear analysis of what risks are and whether regulation is useful for their control. In this paper we provide a parametric model to analyze default risk in derivative contracts. A firm is less likely to default on an obligation on derivatives than on its corporate bonds because bonds are always a liability, while derivatives can be assets. Using default rates for corporate bonds, we provide an upper bound for the default risk of derivatives; one substantially lower than the popular debate seems to imply. Systemic risk is the aggregation of default risks; since default risk has been exaggerated, so has systemic risk. Finally, this debate seems to have ignored what we call "agency risk." Features of widely used incentive contracts for derivatives traders can induce them to take very risky positions, unless they are carefully monitored.

JEL Classification: G22

Suggested Citation

Hentschel, Ludger and Smith, Clifford W., Risks in Derivatives Markets (November 20, 1995). WFIC 96-24. Available at SSRN: https://ssrn.com/abstract=7513

Ludger Hentschel

Alternative Risk Premia Investments ( email )

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HOME PAGE: http://www.ludgerhentschel.com

Clifford W. Smith (Contact Author)

Simon Graduate School of Business, University of Rochester ( email )

Carol Simon Hall 3-202C
Rochester, NY 14627
United States
585-275-3217 (Phone)
585-442-6323 (Fax)

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