Working Paper: CEPR ID: DP13192
Authors: Bruno Biais; Florian Heider; Marie Hoerova
Abstract: Protection buyers use derivatives to share risk with protection sellers, whose assets are only imperfectly pledgeable because of moral hazard. Tomitigate moral hazard, privately optimal derivative contracts involve variation margins. When margins are called, protection sellers must liquidate some of their own assets. We analyse, in a general-equilibrium framework, whether this leads to inefficient fire sales. If investors buying in a fire sale interim can also trade ex ante with protection buyers, equilibrium is information-constrained efficient even though not all marginal rates of substitution are equalized. Otherwise, privately optimal margin calls are inefficiently high. To address this inefficiency, public policy should facilitate ex-ante contracting among all relevant counterparties.
Keywords: variation margins; fire sales; pecuniary externalities; constrained efficiency; macro prudential regulation
JEL Codes: G18; D62; G13; D82
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| variation margins (F12) | fire sales (G33) |
| fire sales (G33) | asset prices (G19) |
| variation margins (F12) | asset prices (G19) |
| ex ante contracting with protection buyers (L14) | market equilibrium (D53) |
| lack of ex ante contracting (D86) | excessively high variation margins (C46) |
| excessively high variation margins (C46) | inefficient asset prices (G19) |
| public policy facilitating ex ante contracting (D86) | market outcomes (P42) |