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

Arbeitspapier

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.

Object Details

• Language: Englisch

References and Relationships

• Bibliographic citation: Series: ECB Working Paper ; No. 1413

Classification and Topics

• Classification: Wirtschaft ; Banks; Depository Institutions; Micro Finance Institutions; Mortgages ; Insurance; Insurance Companies; Actuarial Studies ; Asymmetric and Private Information; Mechanism Design
• Subject: Counterparty risk ; derivatives ; Insurance ; margin requirements ; Moral Hazard

Contributors, Places and Time

• Event: Geistige Schöpfung
• (who): Biais, Bruno ; Heider, Florian ; Hoerova, Marie
• Event: Veröffentlichung
• (who): European Central Bank (ECB)
• (where): Frankfurt a. M.
• (when): 2012

Further information

• Handle: http://hdl.handle.net/10419/153846
• Last update: 10.03.2025, 11:44 AM CET