Variation margins, fire-sales and information-constrained optimality

In order to share risk, protection buyers trade derivatives with protection sellers. Protection sellers’ actions affect the riskiness of their assets, which can create counter-party risk. Because these actions are unobservable, moral hazard limits risk sharing. To mitigate this problem, privately optimal derivative contracts involve variation mar-gins. When margins are called, protection sellers must liquidate some assets, depressing asset prices. This tightens the incentive constraints of other protection sellers and re-duces 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.