Default Risk Mitigation in Derivatives Markets and its Effectiveness

Posted: 9 Jun 2006

See all articles by Carsten Murawski

Carsten Murawski

University of Melbourne - Department of Finance; Financial Research Network (FIRN)

Rajna Gibson

University of Geneva - Geneva Finance Research Institute (GFRI)

Date Written: April 2006

Abstract

Derivatives have become an integral part of the major financial institutions' business and the global derivatives market has grown into the largest market in the world by far. As for any other contract, derivatives are subject to default risk. The set of mechanisms employed by traders to mitigate default risk, such as netting and margining, vary across market types. While exchanges have not experienced any notable credit events in the recent past, over-the-counter markets suffered several, almost systemic events. It seems that the sets of default risk mitigation mechanisms employed by exchanges are more effective at mitigating default risk than those employed by over-the-counter markets.

The broader impacts of these mitigation mechanisms are not yet fully understood, though. In this paper we analyze the effect of different default risk mitigation mechanisms on wealth, market liquidity, and default rates.

We develop a model to investigate the effects of default risk mitigation mechanisms on market, credit, and liquidity risk. Our model captures some of the main characteristics of derivatives markets. The dynamic and non-linear nature of our problem, of liquidity and default in particular, render a formal modelling approach unpromising. We therefore use simulations to evaluate our model.

We find that there exist situations where default risk mitigation mechanisms reduce market liquidity, increase default rates as well as default severity, and the variance of agents' wealth. Such situations include periods of market stress. This means that default risk mitigation mechanisms might have a negative effect on wealth at times when market participants expect them to be most valuable.

Keywords: Derivative securities, over-the-counter markets, default risk, systemic risk, central counterparty

JEL Classification: G19, G21

Suggested Citation

Murawski, Carsten and Gibson, Rajna, Default Risk Mitigation in Derivatives Markets and its Effectiveness (April 2006). EFA 2006 Zurich Meetings Paper. Available at SSRN: https://ssrn.com/abstract=906488

Carsten Murawski (Contact Author)

University of Melbourne - Department of Finance ( email )

Brain, Mind & Markets Lab
Parkville, Victoria 3010
Australia

Financial Research Network (FIRN)

C/- University of Queensland Business School
St Lucia, 4071 Brisbane
Queensland
Australia

HOME PAGE: http://www.firn.org.au

Rajna Gibson

University of Geneva - Geneva Finance Research Institute (GFRI) ( email )

40 Boulevard du Pont d'Arve
Geneva 4, 1211
Switzerland
+41.22.379.89.83 (Phone)

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