Variation margins, fire-sales and information-constrained optimality

Bruno Biais, Florian Heider and Marie Hoerova

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Abstract: In order to share risk, protection buyers trade derivatives with protection sellers. Protection sellers' actions affect the riskiness of their assets, which can create counterparty risk. Because these actions are unobservable, moral hazard limits risk sharing. To mitigate this problem, privately optimal derivative contracts involve variation margins. When margins are called, protection sellers must liquidate some assets, depressing asset prices. This tightens the incentive constraints of other protection sellers and reduces their ability to provide insurance. Despite this fire-sale externality, equilibrium is information-constrained efficient. Investors, who benefit from buying assets at fire-sale prices, optimally supply insurance against the risk of fire sales.

Date: 2021-11
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Published in Review of Economic Studies, 2021, vol. 88 (n° 6), pp.2654-2686. ⟨10.1093/restud/rdaa083⟩

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Related works:
Working Paper: Variation margins, fire-sales and information-constrained optimality (2022)
Journal Article: Variation Margins, Fire Sales, and Information-constrained Optimality (2021)
Working Paper: Variation margins, fire sales, and information-constrained optimality (2018)
Working Paper: Variation margins, fire sales, and information-constrained optimality (2018)
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Persistent link: https://EconPapers.repec.org/RePEc:hal:journl:hal-03546710

DOI: 10.1093/restud/rdaa083

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