Risk-Sharing or Risk-Taking? Counterparty Risk, Incentives and Margins

Abstract

Derivatives activity, motivated by risk-sharing, can breed risk-taking. Bad news about the risk of the asset underlying the derivative increases the expected liability of a protection seller and undermines her risk-prevention incentives. This limits risk-sharing, and may create endogenous counterparty risk and contagion from news about the hedged risk to the balance sheet of protection sellers. Margin calls after bad news can improve protection sellers' incentives and enhance the ability to share risk. Central clearing can provide insurance against counterparty risk but must be designed to preserve risk-prevention incentives.

Keywords: Hedging, Insurance, Derivatives, Moral hazard, Risk management, Counterparty risk, Contagion, Margin requirements

JEL Classification: G21, G22, D82