#96-24
"Risks in Derivatives Markets"
Summary: 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.
This paper was presented at the Financial Institutions Center's May 1996 conference on "Risk Management in Insurance Firms."
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