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Default Ambiguity: Credit Default Swaps Create New Systemic Risks in Financial Networks


Schuldenzucker, Steffen; Seuken, Sven; Battiston, Stefano (2019). Default Ambiguity: Credit Default Swaps Create New Systemic Risks in Financial Networks. Management Science:Epub ahead of print.

Abstract

We study financial networks and reveal a new kind of systemic risk arising from what we call default ambiguity — that is, a situation where it is impossible to decide which banks are in default. Specifically, we study the clearing problem: given a network of banks interconnected by financial contracts, determine which banks are in default and what percentage of their liabilities they can pay. Prior work has shown that when banks can only enter into debt contracts with each other, this problem always has a unique maximal solution. We first prove that when banks can also enter into credit default swaps (CDSs), the clearing problem may have no solution or multiple conflicting solutions, thus leading to default ambiguity. We then derive sufficient conditions on the network structure to eliminate these issues. Finally, we discuss policy implications for the CDS market.

Abstract

We study financial networks and reveal a new kind of systemic risk arising from what we call default ambiguity — that is, a situation where it is impossible to decide which banks are in default. Specifically, we study the clearing problem: given a network of banks interconnected by financial contracts, determine which banks are in default and what percentage of their liabilities they can pay. Prior work has shown that when banks can only enter into debt contracts with each other, this problem always has a unique maximal solution. We first prove that when banks can also enter into credit default swaps (CDSs), the clearing problem may have no solution or multiple conflicting solutions, thus leading to default ambiguity. We then derive sufficient conditions on the network structure to eliminate these issues. Finally, we discuss policy implications for the CDS market.

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Additional indexing

Item Type:Journal Article, refereed, original work
Communities & Collections:03 Faculty of Economics > Department of Informatics
Dewey Decimal Classification:000 Computer science, knowledge & systems
Language:English
Date:26 June 2019
Deposited On:18 Sep 2019 16:13
Last Modified:25 Sep 2019 00:46
Publisher:Institute for Operations Research and the Management Science
ISSN:0025-1909
OA Status:Green
Free access at:Publisher DOI. An embargo period may apply.
Publisher DOI:https://doi.org/10.1287/mnsc.2019.3304
Related URLs:https://www.zora.uzh.ch/id/eprint/149691/
Other Identification Number:merlin-id:18332

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