To share or not to share? Uncovered losses in a derivatives clearinghouse

This paper studies how the allocation of residual losses affects trading and welfare in a central counterparty. I compare loss sharing under two loss-allocation mechanisms - variation margin haircutting and cash calls - and study the privately and socially optimal degree of loss sharing. For losses allocated using variation margin haircuts, I find that trading volume is sensitive to the degree of loss sharing and to the risk sensitivity of skinin-the-game capital. By contrast, for cash calls, the degree of loss sharing does not affect trading volume but instead affects the chance that a cash call is honoured, which can constrain the recovery of funds. A welfare analysis characterizes the market outcome and compares it with the social optimum

Optimal margining and margin relief in centrally cleared derivatives markets

A major policy challenge posed by derivatives clearinghouses is that their collateral requirements can rise sharply in times of stress, reducing market liquidity and further exacerbating downturns. Smoothing sharp changes in collateral requirements - an approach known as through-the-cycle margining - however, has its own disadvantages, one of which is increased risk sharing among clearinghouse members when financial risk is high. This can give rise to undesirable side effects, including distorted incentives, which can reverse the conventional knowledge about collateral policy. In contrast to the existing literature, I show that through-the-cycle margining can increase as well as reduce trading in volatile markets. Due to increased risk sharing, clearinghouse members may prefer to overcollateralize transactions, leading to lower than socially optimal trading. This creates a challenge for policy-makers, since it may be challenging to push for lower collateral standards than deemed proper by the industry. For such cases, I propose an alternative policy tool - increasing default penalties - to align private and social incentives.Un grand défi en matière de politiques que posent les chambres de compensation des produits dérivés est le fait que leurs exigences en matière de garanties peuvent monter en flèche en périodes de tensions, réduisant ainsi la liquidité du marché et exacerbant les ralentissements économiques. Le lissage des brusques variations de ces exigences – que l’on appelle mode de calcul des marges en fonction du cycle intégral – présente cependant ses propres désavantages, dont le partage accru des risques entre les membres des chambres de compensation lorsque le risque financier est élevé. Cela peut avoir des effets secondaires indésirables, notamment la distorsion des incitations, qui peuvent contredire les connaissances généralement admises au sujet des politiques de garantie. Contrairement aux études précédentes, celle-ci montre que le calcul des marges en fonction du cycle intégral peut entraîner une augmentation aussi bien qu’une réduction du volume des opérations sur des marchés volatils. En raison du partage accru des risques, les membres des chambres de compensation préfèrent parfois procéder à un surnantissement, qui donne lieu à un volume d’opérations inférieur au niveau socialement optimal. Cela complique les choses pour les décideurs publics, étant donné qu’il pourrait être difficile de tenter d’imposer des normes de garanties inférieures à celles que le secteur juge adéquates. Dans de tels cas, l’auteur propose une autre mesure de politique – l’augmentation des pénalités en cas de défaut – afin d’harmoniser les incitations d’ordre privé et social

Uncertain costs and vertical differentiation in an insurance duopoly

Classical oligopoly models predict that firms differentiate vertically as a way of softening price competition, but some metrics suggest very little quality differentiation in the U.S. auto insurance market. I explain this phenomenon using the fact that risk-averse insurance companies with uncertain costs face incentives to converge to a homogeneous quality. Quality changes are capable of boosting as well as reducing profits, since quality differentiation softens price competition, but also undermines the lower-end firm's ability to charge the markup commanded by risk aversion. This can make differentiation suboptimal, leading to a homogeneous quality; the outcome depends on consumers' quality tastes and on how costly quality is. Additional trade-offs between quality costs, profits and profit variances compound this effect, resulting in equilibria at very low quality levels. I argue that this provides one explanation of how insurer competition drove quality down in the nineteenth-century U.S. market for fire insurance.Les modèles d’oligopole classiques montrent que les entreprises atténuent la concurrence qu’elles se font sur les prix par la différenciation verticale des produits. Or, certaines mesures laissent croire que le marché de l’assurance automobile aux États-Unis présente un très faible degré de différenciation qualitative. L’auteur explique ce phénomène par le fait que, étant réfractaires au risque et confrontées à des coûts incertains, les companies d’assurance sont portées à opter pour des produits de qualité uniforme. L’introduction de différences de qualité entre les produits peut tout aussi bien accroître les profits que les réduire. En effet, si elle rend moins âpre la concurrence sur les prix, la différenciation qualitative limite également la capacité de la firme offrant la variante de moindre qualité d’inclure dans son prix le taux de marge que commande son aversion pour le risque. Selon les goûts des consommateurs pour la qualité et le prix à payer pour l’obtenir, cela peut faire de la différenciation une stratégie sous-optimale qui serait rejetée au profit de l’homogénéisation de la qualité. D’autres arbitrages entre les coûts rattachés à la qualité du produit, les profits et les variances des profits exacerbent cet effet, de sorte que les équilibres se réalisent à de très bas niveaux de qualité. L’auteur soutient que ce serait là une explication au déclin de la qualité observé au XIXe siècle à la suite de l’intensification de la concurrence sur le marché américain de l’assurance incendie

Essays in Applied Microeconomic Theory

Thesis advisor: Utku UnverThis dissertation consists of three essays in microeconomic theory: two focusing on insurance theory and one on matching theory. The first chapter is concerned with catastrophe insurance. Motivated by the aftermath of hurricane Katrina, it studies a strategic model of catastrophe insurance in which consumers know that they may not get reimbursed if too many other people file claims at the same time. The model predicts that the demand for catastrophe insurance can ``bend backwards'' to zero, resulting in multiple equilibria and especially in market failure, which is always an equilibrium. This shows that a catastrophe market can fail entirely due to demand-driven reasons, a result new to the literature. The model suggests that pricing is key for the credibility of catastrophe insurers: instead of increasing demand, price cuts may backfire and instead cause a ``race to the bottom.'' However, small amounts of extra liquidity can restore the system to stable equilibrium, highlighting the importance of a functioning reinsurance market for large risks. These results remain robust both for expected utility consumer preferences and for expected utility's most popular alternative, rank-dependent expected utility. The second chapter develops a model of quality differentiation in insurance markets, focusing on two of their specific features: the fact that costs are uncertain, and the fact that firms are averse to risk. Cornerstone models of price competition predict that firms specialize in products of different quality (differentiate their products) as a way of softening price competition. However, real-world insurance markets feature very little differentiation. This chapter offers an explanation to this phenomenon by showing that cost uncertainty fundamentally alters the nature of price competition among risk-averse firms by creating a drive against differentiation. This force becomes particularly pronounced when consumers are picky about quality, and is capable of reversing standard results, leading to minimum differentiation instead. The chapter concludes with a study of how the costs of quality affect differentiation by considering two benchmark cases: when quality is costless and when quality costs are convex (quadratic). The third chapter focuses on the theory of two-sided matching. Its main topic are inefficiencies that arise when agent preferences permit indifferences. It is well-known that two-sided matching under weak preferences can result in matchings that are stable, but not Pareto efficient, which creates bad incentives for inefficiently matched agents to stay together. In this chapter I show that in one-to-one matching with weak preferences, the fraction of inefficiently matched agents decreases with market size if agents are sufficiently diverse; in particular, the proportion of agents who can Pareto improve in a randomly chosen stable matching approaches zero when the number of agents goes to infinity. This result shows that the relative degree of the inefficiency vanishes in sufficiently large markets, but this does not provide a "cure-all'' solution in absolute terms, because inefficient individuals remain even when their fraction is vanishing. Agent diversity is represented by the diversity of each person's preferences, which are assumed randomly drawn, i.i.d. from the set of all possible weak preferences. To demonstrate its main result, the chapter relies on the combinatorial properties of random weak preferences.Thesis (PhD) — Boston College, 2012.Submitted to: Boston College. Graduate School of Arts and Sciences.Discipline: Economics

Systemic risk and portfolio diversification: Evidence from the futures market

This paper explores the extent to which correlated investments in the futures market concentrated systemic risk on large Canadian banks around the 2008 crisis. We find that core banks took positions against the periphery, increasing their systemic risk as a group. On the portfolio level, position similarity was the main systemic risk driver for core banks, while crossprice correlations drove the systemic risk of noncore banks. Core banks were more diversified, but their portfolios also overlapped more. By contrast, non-core banks were less diversified, but also overlapped less. This significantly nuances the debate on concentration versus diversification as systemic risk sources

Systemic Risk and Collateral Adequacy: Evidence from the Futures Market

AbstractConventional collateral requirements for derivatives are conservative, but not explicitly designed to buffer systemic risk. I explore collateral adequacy against systemic risk in the Canadian futures market during the 2008 crisis. I find that conventional collateral levels adequately absorb systemic risk, even allowing for an implausibly high level of stress, and that systemic risk spillovers do not exceed the effect of an approximately 1% downward stock price move. I also document that the largest systemic risk contributors are buffered relatively less than the rest, and that there is a large cross-country difference in the behavior of U.S. and Canadian institutions.</jats:p

Is this normal? The cost of assuming that derivatives have normal returns

Derivatives exchanges often determine collateral requirements, which are fundamental to market safety, with dated risk models assuming normal returns. However, derivatives returns are heavy-tailed, which leads to the systematic under-collection of collateral (margin). This paper uses extreme value theory (EVT) to evaluate the cost of this margin inadequacy to market participants in the event of default. I find that the Canadian futures market was under-margined by about $1.6 billion during the Great Financial Crisis, and that the default of the highest-impact participant generates a cost of up to$302 million to be absorbed by surviving participants. I show that this cost can consume the market's entire default fund and result in costly risk mutualization. I advocate for the adoption of EVT as a benchmarking tool and argue that the regulation of exchanges should be revised for financial products with heavy tails

Systemic risk and collateral adequacy: Evidence from the great crisis

Conventional collateral requirements are highly conservative but are not explicitly designed to deal with systemic risk. This paper explores the adequacy of conventional collateral levels against systemic risk in the Canadian futures market during the 2008 crisis. Our results show that conventional collateral levels adequately absorb crisis-level systemic risk, even allowing for an implausibly large margin of error. However, this occurs at the expense of unequal buffering of systemic risk across banks. We document that the largest systemic risk contributors are buffered relatively less than the rest and that there is a large cross-country difference in the behavior of US and Canadian institutions. Nonetheless, even this does not result in meaningful risk spillovers. The maximum expected market shortfall in excess of collateral comes up to at most 1% of the banks' market capitalization, and hence the added systemic risk does not exceed the effect of a 1% downward stock price move

Decomposing large banks' systemic trading losses

Do banks realize simultaneous trading losses because they invest in the same assets, or because different assets are subject to the same macro shocks? This paper decomposes the comovements of bank trading losses into two orthogonal channels: portfolio overlap and common shocks. While portfolio overlap generates strong comovements, I find that the sensitivity to common shocks from non-overlapping assets is larger. This sensitivity operates through two sub-channels: the short-long interest rate correlation and the stock-bond correlation, driven by macroeconomic factors. This reveals a new trade-off whereby reductions in portfolio overlap can increase the comovement of trading losses by adding exposures to macro shocks