Optimal Margins and Equilibrium Prices
45 Pages Posted: 30 Nov 2015
Date Written: September 30, 2015
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: Suggested Citation