CDS as Insurance: Leaky Lifeboats in Stormy Seas

Eric Stephens and James Thompson ()

No 2011-9, Working Papers from University of Alberta, Department of Economics

Abstract: In this paper we update the traditional insurance economics framework to incorporate key features of the credit default swap (CDS) market. First, we allow for insurer insolvency, with asymmetric information as to its probability. We find that stable insurers become less stable because they are forced to compete on price. When insurer type is known, increased competition among insurers can create instability for the same reason. Second, we allow the insured party to have heterogeneous motivations for purchasing CDS. For example, some may own the underlying asset and purchase CDS for risk management, while others buy these contracts purely for speculation. We show that speculators will choose to contract with less stable insurers, resulting in higher counterparty risk in this market relative to that of traditional insurance; however, a regulatory policy that disallows speculative trading can, perversely, cause market counterparty risk to increase. Third, we relax the standard assumption of contract exclusivity, which does not apply to the CDS market, by allowing the insured to purchase contracts from many insurers. In contrast to the traditional insurance model, we show that separation of risk type among insured parties can be achieved through insurer choice. We use our model to shed light on the debate over Central Counterparties (CCP). We show that requiring CDS contracts to be negotiated through CCPs can push stable insurers out of the market, mitigating the benefi t of risk pooling.

Keywords: credit default swaps; insurance; counterparty risk; banking; regulation (search for similar items in EconPapers)
JEL-codes: D82 G18 G21 G22 (search for similar items in EconPapers)
Pages: 39 pages
Date: 2011-06-16, Revised 2011-09-01
New Economics Papers: this item is included in nep-ban, nep-cta, nep-ias, nep-reg and nep-rmg
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (10)

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Journal Article: CDS as insurance: Leaky lifeboats in stormy seas (2014)
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Persistent link: https://EconPapers.repec.org/RePEc:ris:albaec:2011_009

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