Variation margins, fire-sales and information-constrained optimality

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.