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Variation margins, fire-sales and information-constrained optimality

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  • Biais, Bruno
  • Heider, Florian
  • Hoerova, Marie

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 counter-party risk. Because these actions are unobservable, moral hazard limits risk sharing. To mitigate this problem, privately optimal derivative contracts involve variation mar-gins. When margins are called, protection sellers must liquidate some assets, depressing asset prices. This tightens the incentive constraints of other protection sellers and re-duces 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

  • Biais, Bruno & Heider, Florian & Hoerova, Marie, 2022. "Variation margins, fire-sales and information-constrained optimality," TSE Working Papers 126554, Toulouse School of Economics (TSE).
    • Handle: RePEc:tse:wpaper:126554
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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

    Keywords

    variation margins; fire sales; pecuniary externality; moral hazard; con-strained efficiency; regulation;
    All these keywords.

    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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