Controlling risks in derivatives markets

The debate about risks and regulation in derivatives markets has failed to provide a clear analysis of what the risks are and whether regulation is a useful tool for their control. The debate is particularly confusing in the area of what has been termed "systemic" risk. This paper analyzes the risks associated with derivatives transactions. We argue that systemic risk is just the aggregation of individual default risks. And because default risk has been exaggerated, so has systemic risk. Furthermore, the debate seems to have ignored the most prominent risk evident in recent derivatives debacles: what we call "agency risk". After analyzing the risks in derivative markets, we investigate the appropriate role for regulation in their control.

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