Optimal margins and equilibrium prices

Bruno Biais

No 270, 2016 Meeting Papers from Society for Economic Dynamics

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 re-sale ex- ternality, 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.

Date: 2016
New Economics Papers: this item is included in nep-cta
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Working Paper: Optimal margins and equilibrium prices (2017)
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