Journal of Financial and Quantitative Analysis Vol. 57 No. 3 2022
Counterparty Risk in Over-the-Counter Markets
Abstract
We study trading and risk management decisions of banks in over-the-counter markets, accounting for 2 types of risk: payoff risk from loans and counterparty risk from trading activities. Our model provides empirically supported predictions on the structure of the interbank credit default swap (CDS) market: i) banks with high default probabilities either buy or sell CDS contracts; ii) because of the counterparty risk friction, payoff risk is only partially shared; and iii) safe banks act as intermediaries and help diversify counterparty risk. Banks manage their default probabilities to become creditworthy counterparties, but they do so in a socially inefficient way.
- DOI
- 10.1017/s0022109021000491
- Volume
- 57
- Issue
- 3
- Pages
- 1058-1082
- Language
- en
- Sources
- bibtex:phds-export.bib crossref openalex