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Variation margins, fire-sales and information-constrained optimality

Author

Listed:
  • Bruno Biais
  • Florian Heider

    (Unknown)

  • Marie Hoerova

    (Unknown)

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.

Suggested Citation

  • Bruno Biais & Florian Heider & Marie Hoerova, 2021. "Variation margins, fire-sales and information-constrained optimality," Post-Print hal-03546710, HAL.
    • Handle: RePEc:hal:journl:hal-03546710
    DOI: 10.1093/restud/rdaa083
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    Cited by:

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    2. Radoslav Raykov, 2024. "Decomposing Large Banks’ Systemic Trading Losses," Staff Working Papers 24-6, Bank of Canada.
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    4. Vuillemey, Guillaume, 2023. "Mitigating fire sales with a central clearing counterparty," Journal of Financial Intermediation, Elsevier, vol. 55(C).

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    More about this item

    JEL classification:

    • G18 - Financial Economics - - General Financial Markets - - - Government Policy and Regulation
    • D62 - Microeconomics - - Welfare Economics - - - Externalities
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design

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