Paper: arXiv 2310.02608

Authors: Dorinel Bastide, Stéphane Crépey, Samuel Drapeau, Mekonnen Tadese

Abstract

For vanilla derivatives that constitute the bulk of investment banks’ hedging portfolios, central clearing through central counterparties (CCPs) has become hegemonic. A key mandate of a CCP is to provide an efficient and proper clearing member default resolution procedure. When a clearing member defaults, the CCP can hedge and auction or liquidate its positions. The counterparty credit risk cost of auctioning has been analyzed in terms of XVA metrics in Bastide, Cr{é}pey, Drapeau, and Tadese (2023). In this work we assess the costs of hedging or liquidating. This is done by comparing pre- and post-default market equilibria, using a Radner equilibrium approach for portfolio allocation and price discovery in each case. We show that the Radner equilibria uniquely exist and we provide both analytical and numerical solutions for the latter in elliptically distributed markets. Using such tools, a CCP could decide rationally on which market to hedge and auction or liquidate defaulted portfolios.

Complexity vs Empirical Score

  • Math Complexity: 8.5/10
  • Empirical Rigor: 3.0/10
  • Quadrant: Lab Rats — theoretically deep, empirically untested

Why this score: The paper provides a rigorous mathematical treatment of CCP default resolution using Radner equilibrium theory with analytical and numerical existence proofs. However, it lacks empirical backtesting on real-world market data, relying primarily on theoretical modeling and stylized elliptical distribution assumptions.

Research Flowchart

  flowchart TD
    A[Research Goal: Assess costs of hedging vs. liquidating a defaulted clearing member portfolio] --> B[Inputs: Pre/Post-default portfolios & Elliptical market distributions]
    B --> C[Methodology: Radner Equilibrium Approach]
    C --> D[Compute Pre- and Post-default Market Equilibria]
    D --> E[Derive Analytical & Numerical Price Discovery Solutions]
    E --> F[Outcomes: Unique Radner equilibria exist; provides decision framework for CCP default management]