Effects of options on financial stability

Abstract

The lack of collateralized trading in the OTC derivatives market and the absence of any system for the resolution of cross exposures have been highlighted as major causes of the collapse of assets prices during the financial crisis. According to the perfect market hypothesis derivatives are a zero sum game (according to Black-Scholes pricing models) and do not add new risk to the market or modify existing risk. However, these virtues only apply in the real world in the presence of effective regulation, control, and supervision. The perverse effects of the financial crisis sug-gest that it is time to rethink the standard finance theory approach to derivatives.