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Counterparty Risk in Over-the-Counter Markets

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  • Frei, Christoph
  • Capponi, Agostino
  • Brunetti, Celso

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.

Suggested Citation

  • Frei, Christoph & Capponi, Agostino & Brunetti, Celso, 2022. "Counterparty Risk in Over-the-Counter Markets," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 57(3), pages 1058-1082, May.
    • Handle: RePEc:cup:jfinqa:v:57:y:2022:i:3:p:1058-1082_8
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