Optimal margins and equilibrium prices

Bruno Biais, Florian Heider and Marie Hoerova

No 875, IDEI Working Papers from Institut d'Économie Industrielle (IDEI), Toulouse

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 (search for similar items in EconPapers)
JEL-codes: D82 G21 G22 (search for similar items in EconPapers)
Date: 2017-06
New Economics Papers: this item is included in nep-com, nep-cta, nep-ias and nep-mic
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (1)

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Related works:
Working Paper: Optimal margins and equilibrium prices (2017)
Working Paper: Optimal margins and equilibrium prices (2016)
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Persistent link: https://EconPapers.repec.org/RePEc:ide:wpaper:31764

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