CDS as Insurance: Leaky Lifeboats in Stormy Seas
AbstractIn this paper we update the traditional insurance economics framework to incorporate key features of the credit default swap (CDS) market. First, we allow for insurer insolvency, with asymmetric information as to its probability. We find that stable insurers become less stable because they are forced to compete on price. When insurer type is known, increased competition among insurers can create instability for the same reason. Second, we allow the insured party to have heterogeneous motivations for purchasing CDS. For example, some may own the underlying asset and purchase CDS for risk management, while others buy these contracts purely for speculation. We show that speculators will choose to contract with less stable insurers, resulting in higher counterparty risk in this market relative to that of traditional insurance; however, a regulatory policy that disallows speculative trading can, perversely, cause market counterparty risk to increase. Third, we relax the standard assumption of contract exclusivity, which does not apply to the CDS market, by allowing the insured to purchase contracts from many insurers. In contrast to the traditional insurance model, we show that separation of risk type among insured parties can be achieved through insurer choice. We use our model to shed light on the debate over Central Counterparties (CCP). We show that requiring CDS contracts to be negotiated through CCPs can push stable insurers out of the market, mitigating the benefi t of risk pooling.
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Bibliographic InfoPaper provided by University of Alberta, Department of Economics in its series Working Papers with number 2011-9.
Length: 39 pages
Date of creation: 16 Jun 2011
Date of revision:
credit default swaps; insurance; counterparty risk; banking; regulation;
Find related papers by JEL classification:
- D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
- G18 - Financial Economics - - General Financial Markets - - - Government Policy and Regulation
- G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
- G22 - Financial Economics - - Financial Institutions and Services - - - Insurance; Insurance Companies; Actuarial Studies
This paper has been announced in the following NEP Reports:
- NEP-ALL-2011-06-25 (All new papers)
- NEP-BAN-2011-06-25 (Banking)
- NEP-CTA-2011-06-25 (Contract Theory & Applications)
- NEP-IAS-2011-06-25 (Insurance Economics)
- NEP-REG-2011-06-25 (Regulation)
- NEP-RMG-2011-06-25 (Risk Management)
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- Hoy, Michael & Polborn, Mattias, 2000. "The value of genetic information in the life insurance market," Journal of Public Economics, Elsevier, vol. 78(3), pages 235-252, November.
- James R. Thompson, 2007. "Credit Risk Transfer: To Sell or to Insure," Working Papers 1131, Queen's University, Department of Economics.
- Stephens, Eric & Thompson, James, 2012. "Who Participates in Risk Transfer Markets? The Role of Transaction Costs and Counterparty Risk," Working Papers 2012-12, University of Alberta, Department of Economics.
- Stephens, Eric & Thompson, James, 2012. "Separation Without Mutual Exclusion in Financial Insurance," Working Papers 2012-8, University of Alberta, Department of Economics.
- Biais, Bruno & Heider, Florian & Hoerova, Marie, 2012. "Risk-sharing or risk-taking? Counterparty risk, incentives and margins," Working Paper Series 1413, European Central Bank.
- Bruno Biais & Florian Heider & Marie Hoerova, 2012.
"Clearing, Counterparty Risk, and Aggregate Risk,"
IMF Economic Review,
Palgrave Macmillan, vol. 60(2), pages 193-222, July.
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