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Annals of Finance

, Volume 13, Issue 4, pp 355–400 | Cite as

Counterparty risk, central counterparty clearing and aggregate risk

Research Article
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Abstract

I construct a model of bilateral trading of over-the-counter (OTC) derivatives to study the performance of central counterparty (CCP) clearing. I first show how buyers are exposed to counterparty risk under bilateral clearing. I then show how a CCP can fully insure against counterparty risk through risk-mutualization and achieve full idiosyncratic risk-sharing among market participants. I further demonstrate the impact of aggregate risk on CCP clearing and illustrate a scenario in which the CCP fails to provide full insurance against counterparty risk and full idiosyncratic risk-sharing collapses under severe aggregate risk. To insure against aggregate risk and retain full idiosyncratic risk-sharing, sellers’ capital resource is important on top of CCP mutualization. Finally, I allow buyers to costly search for sellers and study the implications of optimal search effort. I show how a moral hazard problem can arise if effort is unobservable, in which case full CCP insurance against counterparty risk is no longer optimal.

Keywords

Counterparty risk Aggregate risk Central counterparty (CCP) clearing Optimal risk-sharing Search and Moral hazard 

JEL Classification

D53 D82 G18 G23 

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Copyright information

© Springer-Verlag GmbH Germany 2017

Authors and Affiliations

  1. 1.Compass LexeconChicagoUSA

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