Who Participates in Risk Transfer Markets? The Role of Transaction Costs and Counterparty Risk
AbstractWe analyze the role of transaction costs in risk transfer markets. For example, when these markets are in their infancy, they are characterized by few contracts and high transaction costs. In this case, we show that only highly risk-averse buyers (e.g., hedgers) exist in the market alongside high quality counterparties, and no asymmetric information can be present on either the quality of the risk being transferred or the quality of the counterparty to which the risk is ceded. With lower transaction costs, we show that less risk-averse buyers (e.g., speculators) will enter the market thereby increasing risk transfer; however, these buyers will choose to contract with less stable counterparties. When transaction costs are low, we show that asymmetric information on the quality of the risk being transferred and of the quality of the counterparties can exist in equilibrium. Finally, we analyze the effect of a transaction tax, which is viewed simply as an increase in transaction costs. Such a tax is shown to push relatively less risk-averse buyers out of the market, which tends to reduce the relative number of unstable counterparties. In addition, we show that it reduces the rents that can be extracted due to asymmetric information.
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Bibliographic InfoPaper provided by University of Alberta, Department of Economics in its series Working Papers with number 2012-12.
Length: 25 pages
Date of creation: 01 Jun 2012
Date of revision:
risk transfer; transaction costs; counterparty risk; transaction taxes;
Find related papers by JEL classification:
- G00 - Financial Economics - - General - - - General
- G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies
- G22 - Financial Economics - - Financial Institutions and Services - - - Insurance; Insurance Companies
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- Stephens, Eric & Thompson, James, 2011. "CDS as Insurance: Leaky Lifeboats in Stormy Seas," Working Papers 2011-9, University of Alberta, Department of Economics.
- James R. Thompson, 2010. "Counterparty Risk in Financial Contracts: Should the Insured Worry about the Insurer?," The Quarterly Journal of Economics, MIT Press, vol. 125(3), pages 1195-1252, August.
- Jean-Sébastien Fontaine & Héctor Pérez Saiz & Joshua Slive, 2012. "When Lower Risk Increases Profit: Competition and Control of a Central Counterparty," Working Papers 12-35, Bank of Canada.
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