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CDS as Insurance: Leaky Lifeboats in Stormy Seas

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Author Info

  • Stephens, Eric

    ()
    (University of Alberta, Department of Economics)

  • Thompson, James

    ()
    (University of Waterloo, School of Accounting and Business)

Abstract

In 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 Info

Paper provided by University of Alberta, Department of Economics in its series Working Papers with number 2011-9.

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Length: 39 pages
Date of creation: 16 Jun 2011
Date of revision:
Handle: RePEc:ris:albaec:2011_009

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Related research

Keywords: credit default swaps; insurance; counterparty risk; banking; regulation;

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References

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  1. James R. Thompson, 2007. "Credit Risk Transfer: To Sell or to Insure," Working Papers 1131, Queen's University, Department of Economics.
  2. 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.
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Cited by:
  1. Biais, Bruno & Heider, Florian & Hoerova, Marie, 2012. "Clearing, counterparty risk and aggregate risk," Working Paper Series 1481, European Central Bank.
  2. 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.
  3. Stephens, Eric & Thompson, James, 2012. "Separation Without Mutual Exclusion in Financial Insurance," Working Papers 2012-8, University of Alberta, Department of Economics.
  4. Biais, Bruno & Heider, Florian & Hoerova, Marie, 2012. "Risk-sharing or risk-taking? Counterparty risk, incentives and margins," Working Paper Series 1413, European Central Bank.

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