Monday, January 26, 2009

The Price of Protection: Derivatives, Default Risk, and Margining

By Rajna Gibson Brandon (University of Geneva - Graduate School of Business (HEC-Geneva); Swiss Finance Institute) and (Carsten Murawski University of Melbourne - Department of Finance)

Abstract: By attaching collateral to a derivatives contract, margining supposedly reduces default risk. In this paper, we first develop a set of testable hypotheses about the effects of margining on banks' welfare, trading volume, and default risk in the context of a stylized banking sector equilibrium model. Subsequently, we test these hypotheses with a market simulation model. Capturing some of the main characteristics of derivatives markets, we identify stress situations in which margining has an ambiguous impact on banks' welfare, increases banks' default risk while reducing their aggregate trading volume. This is the case, in particular, when margin rates are high and collateral is scarce.

Download paper here.

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