Tail Risk Killers: How Math, Indeterminacy, and Hubris Distort Markets

CHAPTER 30Twilight of the Models

There is nothing inherently destabilizing about a single credit-default swap (CDS). You are either in the money or out of the money: One side loses, and the other wins. This means that these derivatives transfer risk, not create it. What creates systemic risk is bad pricing, selective margining, and lack of netting, not the instruments themselves. A clearinghouse facilitates transparent pricing, netting, and straightforward settlement with fewer collateral squeezes.

So what’s the problem? Many people think that Satan himself unleashed CDS on the world.

CDS AND INNOVATION

It is sometimes said that the sheer size of the CDS market is destabilizing in itself. Those gargantuan notional amounts are ambiguous, though. ...