Optimal Margins and Equilibrium Prices

45 Pages Posted: 30 Nov 2015  

Bruno Biais

University of Toulouse 1 - Toulouse School of Economics (TSE)

Florian Heider

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

Marie Hoerova

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

Date Written: September 30, 2015

Abstract

We study the interaction between contracting and equilibrium pricing when risk-averse hedgers purchase insurance from risk-neutral investors subject to moral hazard. Moral hazard limits risk-sharing. In the individually optimal contract, margins are called (after bad news) to improve risk-sharing. But margin calls depress the price of investors' assets, affecting other investors negatively. Because of this fire-sale externality, there is too much use of margins in the market equilibrium compared to the utilitarian optimum. Moreover, equilibrium multiplicity can arise: In a pessimistic equilibrium, hedgers who fear low prices request high margins to obtain more insurance. Large margin calls trigger large price drops, confirming initial pessimistic expectations. Finally, moral hazard generates endogenous market incompleteness, raises risk premia, and induces contagion between asset classes.

Keywords: Insurance; Derivatives; Moral hazard; Risk-management; Margin requirements; Contagion; Fire-sales

JEL Classification: G21, G22, D82

Suggested Citation

Biais, Bruno and Heider, Florian and Hoerova, Marie, Optimal Margins and Equilibrium Prices (September 30, 2015). Available at SSRN: https://ssrn.com/abstract=2696439 or http://dx.doi.org/10.2139/ssrn.2696439

Bruno Biais

University of Toulouse 1 - Toulouse School of Economics (TSE) ( email )

Place Anatole-France
Toulouse Cedex, F-31042
France

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 )

77 Bastwick Street
London, EC1V 3PZ
United Kingdom

Marie Hoerova (Contact Author)

European Central Bank (ECB) ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany

Centre for Economic Policy Research (CEPR) ( email )

77 Bastwick Street
London, EC1V 3PZ
United Kingdom

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