Risk-sharing or risk-taking? Counterparty risk, incentives and margins

Florian Heider, Marie Hoerova and Bruno Biais

No 1413, Working Paper Series from European Central Bank

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 Classification: G21, G22, D82

Keywords: counterparty risk; derivatives; Insurance; margin requirements; moral hazard (search for similar items in EconPapers)
Date: 2012-01
New Economics Papers: this item is included in nep-bec, nep-cta, nep-ias and nep-upt
Note: 276127
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (12)

Downloads: (external link)
https://www.ecb.europa.eu//pub/pdf/scpwps/ecbwp1413.pdf (application/pdf)

Related works:
Journal Article: Risk-Sharing or Risk-Taking? Counterparty Risk, Incentives, and Margins (2016)
Working Paper: Risk-sharing or risk-taking? Counterparty-risk, incentives and margins (2016)
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:ecb:ecbwps:20121413

Access Statistics for this paper

More papers in Working Paper Series from European Central Bank 60640 Frankfurt am Main, Germany. Contact information at EDIRC.
Bibliographic data for series maintained by Official Publications ().