Tail risks and contract design from a financial stability perspective - paper by Paul Fisher

In a co-authored paper presented at a University of Cambridge/Lille Catholic University conference in Cambridge, Paul Fisher – Executive Director for Markets – considers, using practical examples from the crisis, how the true value of a financial contract can differ from what it was intended to be because of a failure to take into account how the financial system as a whole operates. This happens especially during stress situations and therefore affects financial stability.
Published on 01 September 2011

The first category of contracts considered essentially fails to take account of the fact that a rare extreme event – a tail risk – affecting the insured, can also affect the insurer and thus fail to pay out. These risk correlations have not always been taken into account by market participants or regulators in the past. Apparently robust balance sheets, insured against bad outcomes, can look extremely weak once a major system-wide event occurs. The paper considers a number of practical examples, mostly based on the use of credit default swaps (CDS) as the insurance instrument.

PDFPress release

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