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CDS as Insurance: Leaky Lifeboats in Stormy Seas

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Listed:
  • 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.

Suggested Citation

  • Stephens, Eric & Thompson, James, 2011. "CDS as Insurance: Leaky Lifeboats in Stormy Seas," Working Papers 2011-9, University of Alberta, Department of Economics, revised 01 Sep 2011.
  • Handle: RePEc:ris:albaec:2011_009
    as

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    File URL: https://sites.ualberta.ca/~econwps/2011/wp2011-09.pdf
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    References listed on IDEAS

    as
    1. Cummins, J David & Mahul, Olivier, 2003. "Optimal Insurance with Divergent Beliefs about Insurer Total Default Risk," Journal of Risk and Uncertainty, Springer, vol. 27(2), pages 121-138, October.
    2. J. Hirshleifer, 1975. "Speculation and Equilibrium: Information, Risk, and Markets," The Quarterly Journal of Economics, Oxford University Press, vol. 89(4), pages 519-542.
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    11. James R. Thompson, 2007. "Credit Risk Transfer: To Sell or to Insure," Working Papers 1131, Queen's University, Department of Economics.
    12. Stephens, Eric & Thompson, James, 2012. "Separation Without Mutual Exclusion in Financial Insurance," Working Papers 2012-8, University of Alberta, Department of Economics.
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    18. Robert R. Bliss & Robert Steigerwald, 2006. "Derivatives clearing and settlement: a comparison of central counterparties and alternative structures," Economic Perspectives, Federal Reserve Bank of Chicago, issue Q IV, pages 22-29.
    19. repec:oup:rasset:v:1:y:2011:i:1:p:74-95. is not listed on IDEAS
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    Cited by:

    1. Biais, B. & Heider, F. & Hoerova, M., 2013. "Incentive compatible centralised clearing," Financial Stability Review, Banque de France, issue 17, pages 161-168, April.
    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. Samuel Huber & Jaehong Kim, 2015. "The role of trading frictions in financial markets," ECON - Working Papers 211, Department of Economics - University of Zurich, revised Jul 2017.
    4. Eric Stephens & James R. Thompson, 2015. "Separation Without Exclusion in Financial Insurance," Journal of Risk & Insurance, The American Risk and Insurance Association, vol. 82(4), pages 853-864, December.
    5. Bruno Biais & Florian Heider & Marie Hoerova, 2016. "Risk-Sharing or Risk-Taking? Counterparty Risk, Incentives, and Margins," Journal of Finance, American Finance Association, vol. 71(4), pages 1669-1698, August.
    6. Bruno Biais & Florian Heider & Marie Hoerova, 2012. "Clearing, Counterparty Risk, and Aggregate Risk," IMF Economic Review, Palgrave Macmillan;International Monetary Fund, vol. 60(2), pages 193-222, July.
    7. Stephens, Eric & Thompson, James, 2012. "Separation Without Mutual Exclusion in Financial Insurance," Working Papers 2012-8, University of Alberta, Department of Economics.
    8. Stephens, Eric & Thompson, James R., 2017. "Information asymmetry and risk transfer markets," Journal of Financial Intermediation, Elsevier, vol. 32(C), pages 88-99.

    More about this item

    Keywords

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

    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

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