ISDA highlights a selection of research papers on derivatives and risk management.

The Impact of Derivatives Collateralization on Liquidity Risk: Evidence from the Investment Fund Sector

European Central Bank Working Paper Series
By Audrius Jukonis, Elisa Letizia and Linda Rousová

This paper analyzes whether euro area investment funds hold adequate levels of cash and other highly liquid assets to meet liquidity needs from their derivatives exposures under a range of market stress scenarios.

The analysis focuses on liquidity risk arising from variation margin (VM) calls. The authors compare potential VM calls under various scenarios to the funds’ actual liquidity buffers using transaction-by-transaction data on interest rate swaps, equity and currency derivatives.

The stimulation results show 33% of funds with derivatives exposure may not have sufficient cash buffers to absorb VM calls under a one-day scenario. The overall cash shortfall is estimated to reach €31 billion. Under a prolonged market turmoil scenario, 13% of funds don’t have sufficient liquidity buffers, with an estimated liquidity shortfall of around €76 billion.

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Bank Funding Risk, Reference Rates and Credit Supply

Federal Reserve Bank of New York Staff Reports
By Harry Cooperman, Darrell Duffie, Stephan Luck, Zachry Wang and Yilin (David) Yang

This paper examines how the choice of loan reference rates affects the supply of revolving credit lines. The transition from LIBOR to SOFR could lead to heavier drawdowns on credit lines during periods of market stress.

Credit-sensitive reference rates, such as LIBOR, typically rise in a stressed market environment, reducing borrowers’ incentives to draw on committed credit lines. Risk-free reference rates typically fall when markets are stressed. This gives an incentive to borrowers to draw more heavily on credit lines when bank funding costs rise.

The paper suggests this behavior is priced into the terms of SOFR-linked lines, increasing the expected cost of drawn credit and reducing credit line commitment. The impact of the transition on credit supply varies significantly across different types of banks.

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Is Climate Transition Risk Priced into Corporate Credit Risk? Evidence from Credit Default Swaps

Center for European Studies Paper Series
By Andrea Ugolini, Juan C. Reboredo and Javier Ojea-Ferreiro

This paper examines whether climate transition risk is reflected in the pricing of credit risk of firms. Credit risk is measured by single-name credit default swap (CDS) spreads over different time horizons. A higher CDS spread indicates greater perceived credit risk for a reference entity. To measure transition risk, the authors constructed a climate transition risk (CTR) factor that assesses the vulnerability of a firm’s value to transition to a low carbon economy.

The study analyzes the relevance of the CTR factor for corporate CDS spreads for a sample of European firms from January 2014 to June 2022. The analysis shows firms that are highly vulnerable to CTR have higher CDS spreads, especially over a long period.

The study also assesses how CTR would impact credit risk under three climate transition scenarios. The authors find that climate transition policies have a more significant impact on the credit risk of more vulnerable firms. The findings suggest that firms better prepared for a transition to a low carbon economy have a lower cost of capital and are better protected from the effects of climate transition policies.

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