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

49 Pages Posted: 13 Jan 2012

See all articles by Bruno Biais

Bruno Biais

Centre for Economic Policy Research (CEPR)

Florian Heider

European Central Bank (ECB); Centre for Economic Policy Research (CEPR)

Marie Hoerova

European Central Bank (ECB); Centre for Economic Policy Research (CEPR)

Multiple version iconThere are 2 versions of this paper

Date Written: January 3, 2012

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.

Keywords: insurance, moral hazard, counterparty risk, margin requirements, derivatives

JEL Classification: G21, G22, D82

Suggested Citation

Biais, Bruno and Heider, Florian and Hoerova, Marie, Risk-Sharing or Risk-Taking? Counterparty Risk, Incentives and Margins (January 3, 2012). ECB Working Paper No. 1413, Available at SSRN: https://ssrn.com/abstract=1978717

Bruno Biais (Contact Author)

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

Florian Heider

European Central Bank (ECB) ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany

HOME PAGE: http://https://sites.google.com/site/florianheider2/

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

Marie Hoerova

European Central Bank (ECB) ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

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