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Contagion in Derivatives Markets

Author

Listed:
  • Mark Paddrik

    (Office of Financial Research, U.S. Department of the Treasury, Washington, District of Columbia 20220)

  • Sriram Rajan

    (Office of Financial Research, U.S. Department of the Treasury, Washington, District of Columbia 20220)

  • H. Peyton Young

    (Office of Financial Research, U.S. Department of the Treasury, Washington, District of Columbia 20220; London School of Economics, London AC2A 2AE, United Kingdom; Nuffield College, Oxford OX1 1NF, United Kingdom)

Abstract

A major credit shock can induce large intraday variation margin payments between counterparties in derivatives markets, which may force some participants to default on their payments. These payment shortfalls become amplified as they cascade through the network of exposures. Using detailed Depository Trust & Clearing Corporation data, we model the full network of exposures, shock-induced payments, initial margin collected, and liquidity buffers for about 900 firms operating in the U.S. credit default swaps market. We estimate the total amount of contagion, the marginal contribution of each firm to contagion, and the number of defaulting firms for a systemic shock to credit spreads. A novel feature of the model is that it allows for a range of behavioral responses to balance sheet stress, including delayed or partial payments. The model provides a framework for analyzing the relative effectiveness of different policy options, such as increasing margin requirements or mandating greater liquidity reserves.

Suggested Citation

  • Mark Paddrik & Sriram Rajan & H. Peyton Young, 2020. "Contagion in Derivatives Markets," Management Science, INFORMS, vol. 66(8), pages 3603-3616, August.
    • Handle: RePEc:inm:ormnsc:v:66:y:2020:i:8:p:3603-3616
    DOI: 10.1287/mnsc.2019.3354
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    More about this item

    Keywords

    financial networks; contagion; stress testing; credit default swaps;
    All these keywords.

    JEL classification:

    • D85 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Network Formation
    • G23 - Financial Economics - - Financial Institutions and Services - - - Non-bank Financial Institutions; Financial Instruments; Institutional Investors
    • L1 - Industrial Organization - - Market Structure, Firm Strategy, and Market Performance

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