New Developments in Derivatives Markets: Flow of Risk, Financial Innovation, and Pricing Models
Saturday, Jan. 7, 2017 1:00 PM – 3:00 PM
Hyatt Regency Chicago, Crystal C
- Chair: Darrell Duffie, Stanford University
The Market-Implied Probability of European Government Intervention in Distressed Banks
AbstractExploiting a 2014 change in credit default swap (CDS) contracts on European banks, we find that market expectations of European government support for distressed banks have decreased—an important development in the credibility of financial reforms. CDS contract terms were changed to cover losses from “government intervention” and related bail-in events. For many large European banks, subordinated CDS spreads are available under both the old and new contract terms; the difference (or basis) between the two spreads measures the market price of protection against losses from certain government actions that have mainly imposed losses on subordinated debt holders. Since 2014, the basis has declined, relative to the level of CDS spreads. We argue that this decline in the relative basis reflects a market perception that gov-
ernments are less likely to protect creditors in an event of financial distress, and that banks do
not have sufficient subordinated debt to protect senior bond holders in such an event.
How Does Risk Flow in the Credit Default Swap Market?
AbstractWe develop a framework to analyse the Credit Default Swaps (CDS) market as a network of risk transfers among counterparties. From a theoretical perspective, we introduce the notion of flow-of-risk and provide sufficient conditions for a bow-tie network architecture to endogenously emerge as a result of intermediation. This architecture shows three distinct sets of counterparties: i) Ultimate Risk Sellers (URS), ii) Dealers (indirectly connected to each other), iii) Ultimate Risk Buyers (URB). We show that the probability of widespread distress due to counterparty risk is higher in a bow-tie architecture than in more fragmented network structures. Empirically, we analyse a unique global dataset of bilateral CDS exposures on major sovereign and financial reference entities in 2011 −2014. We find the presence of a bow-tie network architecture consistently across both reference entities and time, and that the flow-of-risk originates from a large number of URSs (e.g. hedge funds) and ends up in a few leading URBs, most of which are non-banks (in particular asset managers). Finally, the analysis of the CDS portfolio composition of the URBs shows a high level of concentration: in particular, the top URBs often show large exposures to potentially correlated reference entities.
Compressing Over-the-Counter Markets
AbstractIn this paper, we show both theoretically and empirically that the size of over-the-counter (OTC) markets with outstanding trades can be reduced without affecting individual net positions. First, we find that the networked nature of OTC markets generates an excess of notional obligations between the aggregate gross amount and the minimum amount required to satisfy each individual net position. Second, we show conditions under which such excess can be removed while preserving individual net positions. We refer to this operation as “compression” and identify feasibility and efficiency criteria, highlighting intermediation as a key factor for excess levels. We show that a trade-off exists between the amount of notional that can be removed from the system and the conservation of trading relationships. Third, we apply our theoretical framework to a unique and comprehensive transaction-level dataset on OTC derivatives. We document large levels of excess across all markets and time. Finally, we show that compression when applied at the global level can reduce a considerable fraction of total notional even under conservative approaches.
- G1 - Asset Markets and Pricing