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Managing Counterparty Risk in OTC Markets

Christoph Frei, Agostino Capponi and Celso Brunetti ()

No 2017-083, Finance and Economics Discussion Series from Board of Governors of the Federal Reserve System (U.S.)

Abstract: We study how banks manage their default risk before bilaterally negotiating the quantities and prices of over-the-counter (OTC) contracts resembling credit default swaps (CDSs). We show that the costly actions exerted by banks to reduce their default probabilities are not socially optimal. Depending on the imposed trade size limits, risk-management costs and sellers' bargaining power, banks may switch from choosing default risk levels above the social optimum to reducing them even below the social optimum. We use a unique and comprehensive data set of bilateral exposures from the CDS market to test the main model implications on the OTC market structure: (i) intermediation is done by low-risk banks with medium credit exposure; (ii) all banks with high credit exposures are net buyers of CDSs, and low-risk banks with low credit exposures are the main net sellers; and (iii) heterogeneity in post-trade credit exposures is higher for riskier banks and smaller for safer banks.

Keywords: Over-the-counter markets; Counterparty risk; Credit default swaps; Search (search for similar items in EconPapers)
JEL-codes: G11 G12 G21 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-ban, nep-fmk and nep-rmg
Date: 2017-08-15
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