The Price of Protection: Derivatives, Default Risk, and Margining
By attaching collateral to a derivatives contract, margining supposedly reduces default risk. In this paper, we rst develop a set of testable hypotheses about the e ects of margining on banks' welfare, trading volume, and default risk in the context of a stylized banking sector equilibrium model. Subsequently, we test these hypotheses with a market simulation model. Capturing some of the main characteristics of derivatives markets, we identify stress situations in which margining has an ambiguous impact on banks' welfare, increases banks' default risk while reducing their aggregate trading volume. This is the case, in particular, when margin rates are high and collateral is scarce.
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