Reference

Bruno Biais, Florian Heider, and Marie Hoerova, Optimal margins and equilibrium prices, IDEI Working Paper, n. 875, June 2017.

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;

JEL codes

  • D82: Asymmetric and Private Information • Mechanism Design
  • G21: Banks • Depository Institutions • Micro Finance Institutions • Mortgages
  • G22: Insurance • Insurance Companies • Actuarial Studies

Research partnership

Fédération des Banques Françaises Research Initiative