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Bruno Biais
- 30 October 2018
- WORKING PAPER SERIES - No. 2191Details
- Abstract
- Protection buyers use derivatives to share risk with protection sellers, whose assets are only imperfectly pledgeable because of moral hazard. To mitigate moral hazard, privately optimal derivative contracts involve variation margins. When margins are called, protection sellers must liquidate some of their own assets. We analyse, in a general-equilibrium framework, whether this leads to inefficient fire sales. If investors buying in a fire sale interim can also trade ex ante with protection buyers, equilibrium is information-constrained efficient even though not all marginal rates of substitution are equalized. Otherwise, privately optimal margin calls are inefficiently high. To address this inefficiency, public policy should facilitate ex-ante contracting among all relevant counterparties.
- JEL Code
- G18 : Financial Economics→General Financial Markets→Government Policy and Regulation
D62 : Microeconomics→Welfare Economics→Externalities
G13 : Financial Economics→General Financial Markets→Contingent Pricing, Futures Pricing
D82 : Microeconomics→Information, Knowledge, and Uncertainty→Asymmetric and Private Information, Mechanism Design
- 1 October 2012
- WORKING PAPER SERIES - No. 1481Details
- Abstract
- We study the optimal design of clearing systems. We analyze how counterparty risk should be allocated, whether traders should be fully insured against that risk, and how moral hazard affects the optimal allocation of risk. The main advantage of centralized clearing, as opposed to no or decentralized clearing, is the mutualization of risk. While mutualization fully insures idiosyncratic risk, it cannot provide insurance against aggregate risk. When the latter is significant, it is efficient that protection buyers exert effort to find robust counterparties, whose low default risk makes it possible for the clearing system to withstand aggregate shocks. When this effort is unobservable, incentive compatibility requires that protection buyers retain some exposure to counterparty risk even with centralized clearing.
- JEL Code
- G22 : Financial Economics→Financial Institutions and Services→Insurance, Insurance Companies, Actuarial Studies
G28 : Financial Economics→Financial Institutions and Services→Government Policy and Regulation
D82 : Microeconomics→Information, Knowledge, and Uncertainty→Asymmetric and Private Information, Mechanism Design
- 10 January 2012
- WORKING PAPER SERIES - No. 1413Details
- Abstract
- We analyze optimal hedging contracts and show that although hedging aims at sharing risk, it can lead to more risk-taking. News implying that a hedge is likely to be loss-making undermines the risk-prevention incentives of the protection seller. This incentive problem limits the capacity to share risks and generates endogenous counterparty risk. Optimal hedging can therefore lead to contagion from news about insured risks to the balance sheet of insurers. Such endogenous risk is more likely to materialize ex post when the ex ante probability of counterparty default is low. Variation margins emerge as an optimal mechanism to enhance risk-sharing capacity. Paradoxically, they can also induce more risk-taking. Initial margins address the market failure caused by unregulated trading of hedging contracts among protection sellers.
- JEL Code
- G21 : Financial Economics→Financial Institutions and Services→Banks, Depository Institutions, Micro Finance Institutions, Mortgages
G22 : Financial Economics→Financial Institutions and Services→Insurance, Insurance Companies, Actuarial Studies
D82 : Microeconomics→Information, Knowledge, and Uncertainty→Asymmetric and Private Information, Mechanism Design