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Cooperation: the bright side of

financial derivatives?
…aka…Risk allocation: the double
face of financial derivatives
Fulvio Corsi, Hykel Hosni and Stefano Marmi
Enterprise Risk Management and Corporate Governance
for Insurance Firms
17 May 2011 - EDHEC Business School – Lille
Paper available here:
Derivatives: a boon to humanity or
weapons of financial mass destruction?

• Irving Fisher (1906): “risk is one of the direst economic evils, and
all of the devices which aid in overcoming it - whether increased
guarantees, safeguards, foresight, insurance or legitimate
speculation - represent a great boon to humanity”

• Engle (2009): “a considerable portion of financial innovation over

the last 30 years has come from the emergence of derivative

• Warren Buffett (2002): “I view derivatives as time bombs, both for

the parties that deal in them and the economic system.(…) In my
view, derivatives are financial weapons of mass destruction,
carrying dangers that, while now latent, are potentially lethal”.

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Both things can be true!
• Derivatives do allow for a more efficient risk management, they
have an important informative role (price discovery) and they may
also provide more liquidity to markets

• However their positive contribution to firm value is not beyond any

reasonable doubt

• In the global financial crisis of 2007-2008 certain derivatives have

magnified contagion and systemic risk: the Federal Reserve
Chairman Ben Bernanke has characterized AIG operations in
derivative markets as the behaviour of a "quasi-hedge fund" that
“made irresponsible bets and took huge losses".

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From Markowitz to systemic risk
• Classical mean-variance separation theorem: optimal market portfolio
weights of risky assets are independent of individual preferences.
Agents decide leverage according to individual risk tolerance
• The agent leverage choice does not affect the joint probability
distribution of the returns in the economy.
• However different degrees of leverage, and hence different amounts
of aggregate investment, can and do affect total output of the
– risk externalities stemming from the size of institutions (TBTF)
– not constant return to scale of the projects
– not constant correlation
– different levels of credit risk which also induce different level of
systemic risk.
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Individiual choices and systemic risk
• A third dimension appears: the total amount of systemic risk
reached as a consequence of the individuals choices

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A simple model
• M risky assets
• N agents, each with initial equity capital Ci
(risk capacity)
• ri = gross return per unit of capital invested
• μi = expected value of ri and σi its risk
• Ii = amount invested in the portfolio of risky
• Agent i will default when loss on his risky
portflolio will exceed Ci
• Probability of default PDi = P(Ii ri < - Ci)
• Distance to default: DDi = Ci / (Ii σi )
• The larger is the investment Ii the smaller
will be DDi
• Return On Equity: ROEi = Ii μi /Ci is an
increasing function of investment.
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Investment choices and estimation errors

• Assume agents maximize a Constant Absolute Risk Aversion

(CARA) utility function with absolute risk aversion parameter
αi. If the risk free rate is zero, each individual i then maximizes
max Ii μi – αi Ii2 σi2/2
• Optimal level Ii* of investment: Ii* = μi / (αi σi2)
• But in practice true values of μi and σi are not known! Instead
use estimates μi and σi thus: Ii* = μi / (αi σi2) = Ii*ei
where ei = σi2 μi / (σi2 μi) is the estimation error.
• The realized distance to default becomes
DDi* = Ci /(Ii* σi ) = 1/(λi σi ei )
where λi = Ii / Ci is the leverage of the i-th agent position

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Statistics vs. a-priori probability
• Ergodic theory studies the statistical behaviour
of the time evolution of systems restricting the
attention to their asymptotic distribution. One
waits until all transients have been wiped off
and looks for an invariant probability measure
describing the distribution of typical orbits.
• The probability of an event (if it exists) is almost
always impossible to be known a-priori
• The only possibility is to replace it with the
frequencies (if they exist) measured by
observing how often the event occurs
• The problem of backtesting
• The problem of ergodicity and of typical points: Douady and Taleb’s Statistical
from a single series of observations I would like Undecidability: under which
to be able to deduce the invariant probability assumptions is it possible and how to
• Bertrand Russell’s chicken make a decision based on the
observation of random variable? The
fourth quadrant…
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Systemic risk

• Aggregate Systemic Risk (SR) = probability that the number of

defaults (ND) in the whole economy exceeds a certain threshold
SRn = P(ND > n)
• SR is an increasing function of λi and σi
• Assume uncorrelated individual estimation errors ei but SR is an
increasing function of the variance of ei
• SR will also be an increasing function of the average correlation
ρ among the individual probabilities of default

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Systemic risk literature
A collection of measures of systemic risk, each
designed to capture certain aspects (liquidity, leverage,
fragility, interconnection, losses, etc.).
1. CoVaR (Adrian and Brunnermeier, 2009): VaR
of economy conditional on distress of agent i
2. Systemic Expected Shortfall (SES) and
Marginal Expected Shortfall (MES) (Acharya,
Pedersen, Philippon and Richardson, 2010): SES
measures each agent’s contribution to systemic
risk, MES measures institution’s losses in the tail
of the system’s loss distribution
3. Distress Insurance Premium (Huang, Zhou,
and Zhu, 2010)
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Systemic risk literature

4. Rare Outcomes (Duggey, 2009)

5. Conditional Marginal Expected Shortfall (Brownlees and Engle,
(2010)): here the marginal ES of an agent is computed conditional on a
fixed market decline
6. Econometric measures of systemic risk in the finance and insurance
sectors (Billio, Getmansky, Lo, and Pelizzon 2010) here the
interconnectedness among the monthly returns of hedge funds, banks,
brokers, and insurance companies is measured by PCA and Granger-
causality tests.
7. Liaisons Dangereuses: Increasing Connectivity, Risk Sharing, and
Systemic Risk (Battiston, Delli Gatti, Gallegati, Greenwald and Stiglitz
2009): non monotonicity of dependence of SR on networks’ connectivity

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Socially efficient frontier and
cooperative financial derivatives
• The total gross return of the
whole economy will be
Y   I i ri
i 1
• We define an allocation to be
socially efficient if it minimizes
the SR for any given level of
E[Y], or if it , maximizes the
expected value of E[Y] for any
given level of SR

• A derivative is said to be socially efficient or cooperative if it permits

to move from an interior and inefficient point to a superior aggregate
risk allocation having a higher E[Y] with same or lower SR (i.e.
moving in the second quadrant direction in the SR - E[Y] plane).
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Asset Backed Securities
ABS exposed financial institutions to more systemic risk through:
• increased Var(ei) (lack of transparency);
• a positive bias in ei, i.e. E[ei] > 1 (mispricing and moral
• increased individual leverages λi
• increased correlation of default probabilities, which magnifies
SRn = P(ND > n)

According to our definition ABS were not (in that form)

cooperative or socially efficient: even if E [Y] might increase, SR
is also increased, and the net change in the position of the
economy in the return-systemic risk space does not dominate the
initial one.

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Credit Default Swaps
• CDS are simply a form of insurance against default. They do
not require an exposure to the underlying credit risk (naked
• Non-naked CDS transfer credit risk from protection buyer to
protection seller: SR change depends on the relative risk
capacity of the two parties.
• Naked CDS increase the total amount of counterparty risk.
The risk over the two sides does not necessarily compensate.
• Since the market of CDS is highly concentrated in few large
protection sellers, the counterparty risk generated by the
default of one of these dominant actors can generate default
contagion and domino effects.
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Credit Default Swaps

• Cont (2010): We argue that the impact of credit default swap

markets on financial stability crucially depends on clearing
mechanisms and capital and liquidity requirements for large
protection sellers. In particular, the culprits are not so much
speculative or “naked” credit default swaps but inadequate
risk management and supervision of protection sellers. When
protection sellers are inadequately capitalised, OTC (over-the-
counter) CDS markets may act as channels for contagion and
systemic risk.

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Credit Default Swaps
The introduction of CDS have both positive and negative effects on SR
and E[Y]:
• price discovery on the creditworthiness of the issuer reduces Var(ei)
(and possibly bias) and hence SR;
• if credit risk is allocated to more capitalized and diversified subjects,
it either decreases SR or it increases E[Y];
• if CDS transfer credit risk to more leveraged and systemically
important institutions SR will increase;
• CDS can magnify the underlying credit risk by compounding it with
the counterparty risk of the protection sellers thus increasing the
possibility of contagion, which increases SRn = P(ND > n)
The social efficiency of CDS remains unclear, depending on which of
the above effects eventually dominates.

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• Financial, insurance firms and regulatory and supervising

authorities should all cooperate to provide more direct and
better quality information concerning the leverage and
linkages among financial institutions, much of which is
currently proprietary and not available to any single regulator.
• An integrated approach, which aims at the control of the
buildup of systemic risk by using econometric and statistical
relationships as well as financial statements and regulatory
data and performance measures, is probably the correct way of
addressing the complexity of the global financial system.
• Firms need to take into account these global factors in their
financing and operational choices (feedbacks).

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Thank you !