Financial institutions are connected to each other via a sophisticated network of bilateral exposures originating from derivatives trades, such as options, futures and credit default swaps. Such trades expose each counterparty not only to market risk, but also to counterparty risk. Indeed, through these linkages, distress or failure of a financial institution triggering large unexpected losses on its trades can seriously affect the financial status of its counterparties in the network, possibly leading them into default. The recursive interdependence in this network of exposures is typically referred to as systemic risk and has been responsible for many failures and credit quality deteriorations experienced by mono-line insurers and investment banks during the crisis. The intricate structure of linkages can be naturally captured via a network representation of the financial system. These networks model the interlinking exposures between financial institutions, and can thus assist in detecting important shock transmission mechanisms.
Dynamic Contagion Mechanisms in Financial Networks