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Atlanta Fed Working Papers

The Impact of a Dealer's Failure on OTC Derivatives Market Liquidity during Volatile Periods

Larry D. Wall, Ellis W. Tallman, and Peter A. Abken
Federal Reserve Bank of Atlanta
Working Paper 96-6
June 1996

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This paper develops a model in which information losses may be an important part of the cost of an OTC derivatives dealer's failure. A dealer failure forces solvent counterparties of a failed dealer to seek replacement hedges with other dealers. However, by forcing good firms into the derivatives market, the failure provides camouflage for insolvent firms seeking to speculate with a dealer that does not know their credit status. The paper models this information loss and uses the model to quantitatively evaluate a range of scenarios. The results suggest that a market breakdown is unlikely but not quite impossible.

JEL classification: G28, E44

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