Model Setup Perfect Information Asymmetric Info - Seller Quality Asymmetric Info - Underlying Risk Transaction Tax Who Participates in Risk Transfer Markets? The Role of Transaction Costs and Counterparty Risk Eric Stephens James R. Thompson University of Alberta University of Waterloo Presented at: CES, Munich September 06, 2012 Eric Stephens and James R. Thompson School of Accounting and Finance, University of Waterloo Who Participates in Risk Transfer Markets? The Role of Transaction Costs and Counterparty Risk 1 / 37
Model Setup Perfect Information Asymmetric Info - Seller Quality Asymmetric Info - Underlying Risk Transaction Tax In the Beginning... • Some party has risk that they would like transferred. No instruments available. • Risk shedder (buyer) locates risk taker (seller): Costly. • Then the real fun begins.. Eric Stephens and James R. Thompson School of Accounting and Finance, University of Waterloo Who Participates in Risk Transfer Markets? The Role of Transaction Costs and Counterparty Risk 2 / 37
Model Setup Perfect Information Asymmetric Info - Seller Quality Asymmetric Info - Underlying Risk Transaction Tax In the Beginning... • Some party has risk that they would like transferred. No instruments available. • Risk shedder (buyer) locates risk taker (seller): Costly. • Then the real fun begins.. Eric Stephens and James R. Thompson School of Accounting and Finance, University of Waterloo Who Participates in Risk Transfer Markets? The Role of Transaction Costs and Counterparty Risk 2 / 37
Model Setup Perfect Information Asymmetric Info - Seller Quality Asymmetric Info - Underlying Risk Transaction Tax In the Beginning... • Some party has risk that they would like transferred. No instruments available. • Risk shedder (buyer) locates risk taker (seller): Costly. • Then the real fun begins.. Eric Stephens and James R. Thompson School of Accounting and Finance, University of Waterloo Who Participates in Risk Transfer Markets? The Role of Transaction Costs and Counterparty Risk 2 / 37
Model Setup Perfect Information Asymmetric Info - Seller Quality Asymmetric Info - Underlying Risk Transaction Tax In the Beginning... • Some party has risk that they would like transferred. No instruments available. • Risk shedder (buyer) locates risk taker (seller): Costly. • Then the real fun begins.. Eric Stephens and James R. Thompson School of Accounting and Finance, University of Waterloo Who Participates in Risk Transfer Markets? The Role of Transaction Costs and Counterparty Risk 2 / 37
Model Setup Perfect Information Asymmetric Info - Seller Quality Asymmetric Info - Underlying Risk Transaction Tax In the Beginning... • Some party has risk that they would like transferred. No instruments available. • Risk shedder (buyer) locates risk taker (seller): Costly. • Then the real fun begins.. Eric Stephens and James R. Thompson School of Accounting and Finance, University of Waterloo Who Participates in Risk Transfer Markets? The Role of Transaction Costs and Counterparty Risk 2 / 37
Model Setup Perfect Information Asymmetric Info - Seller Quality Asymmetric Info - Underlying Risk Transaction Tax As Contract Catches On... • The most common contract terms are standardized • Intermediaries begin to appear to locate counterparties Eric Stephens and James R. Thompson School of Accounting and Finance, University of Waterloo Who Participates in Risk Transfer Markets? The Role of Transaction Costs and Counterparty Risk 3 / 37
Model Setup Perfect Information Asymmetric Info - Seller Quality Asymmetric Info - Underlying Risk Transaction Tax As Contract Catches On... • The most common contract terms are standardized • Intermediaries begin to appear to locate counterparties Eric Stephens and James R. Thompson School of Accounting and Finance, University of Waterloo Who Participates in Risk Transfer Markets? The Role of Transaction Costs and Counterparty Risk 3 / 37
Model Setup Perfect Information Asymmetric Info - Seller Quality Asymmetric Info - Underlying Risk Transaction Tax Liquid OTC • Vast majority standardized. • Intermediaries control market. Eric Stephens and James R. Thompson School of Accounting and Finance, University of Waterloo Who Participates in Risk Transfer Markets? The Role of Transaction Costs and Counterparty Risk 4 / 37
Model Setup Perfect Information Asymmetric Info - Seller Quality Asymmetric Info - Underlying Risk Transaction Tax Liquid OTC • Vast majority standardized. • Intermediaries control market. Eric Stephens and James R. Thompson School of Accounting and Finance, University of Waterloo Who Participates in Risk Transfer Markets? The Role of Transaction Costs and Counterparty Risk 4 / 37
Model Setup Perfect Information Asymmetric Info - Seller Quality Asymmetric Info - Underlying Risk Transaction Tax Questions • How do transaction costs affect the players and the quality of risk transfer (e.g., OTC) markets? • How do asymmetric information and transaction costs interact? Eric Stephens and James R. Thompson School of Accounting and Finance, University of Waterloo Who Participates in Risk Transfer Markets? The Role of Transaction Costs and Counterparty Risk 5 / 37
Model Setup Perfect Information Asymmetric Info - Seller Quality Asymmetric Info - Underlying Risk Transaction Tax Questions • How do transaction costs affect the players and the quality of risk transfer (e.g., OTC) markets? • How do asymmetric information and transaction costs interact? Eric Stephens and James R. Thompson School of Accounting and Finance, University of Waterloo Who Participates in Risk Transfer Markets? The Role of Transaction Costs and Counterparty Risk 5 / 37
Model Setup Perfect Information Asymmetric Info - Seller Quality Asymmetric Info - Underlying Risk Transaction Tax Main Results • With Perfect Info: ◮ lower transaction costs increases number of low-risk averse buyers (“speculators”) and more unstable counterparties. • Unknown Counterparty quality: ◮ High transaction costs: Market can collapse ◮ Low transaction costs: unstable sellers (e.g., insurers) extract info rents. Relative number of unstable counterparties can go up or down. Eric Stephens and James R. Thompson School of Accounting and Finance, University of Waterloo Who Participates in Risk Transfer Markets? The Role of Transaction Costs and Counterparty Risk 6 / 37
Model Setup Perfect Information Asymmetric Info - Seller Quality Asymmetric Info - Underlying Risk Transaction Tax Main Results • With Perfect Info: ◮ lower transaction costs increases number of low-risk averse buyers (“speculators”) and more unstable counterparties. • Unknown Counterparty quality: ◮ High transaction costs: Market can collapse ◮ Low transaction costs: unstable sellers (e.g., insurers) extract info rents. Relative number of unstable counterparties can go up or down. Eric Stephens and James R. Thompson School of Accounting and Finance, University of Waterloo Who Participates in Risk Transfer Markets? The Role of Transaction Costs and Counterparty Risk 6 / 37
Model Setup Perfect Information Asymmetric Info - Seller Quality Asymmetric Info - Underlying Risk Transaction Tax Main Results • Unknown risk being transferred: ◮ High transaction costs: Only perfect info possible. • Transaction tax: ◮ decrease speculation, increase market quality and decrease information rent. ◮ decrease risk transfer, extreme cases will shut down market. Eric Stephens and James R. Thompson School of Accounting and Finance, University of Waterloo Who Participates in Risk Transfer Markets? The Role of Transaction Costs and Counterparty Risk 7 / 37
Model Setup Perfect Information Asymmetric Info - Seller Quality Asymmetric Info - Underlying Risk Transaction Tax Main Results • Unknown risk being transferred: ◮ High transaction costs: Only perfect info possible. • Transaction tax: ◮ decrease speculation, increase market quality and decrease information rent. ◮ decrease risk transfer, extreme cases will shut down market. Eric Stephens and James R. Thompson School of Accounting and Finance, University of Waterloo Who Participates in Risk Transfer Markets? The Role of Transaction Costs and Counterparty Risk 7 / 37
Model Setup Perfect Information Asymmetric Info - Seller Quality Asymmetric Info - Underlying Risk Transaction Tax Literature • Transaction costs: Focuses on demand, prices and volatility. ◮ e.g., Vayanos (1998), Vayanos and Vila (1999), Lo, Mamaysky and Wang (2005) • Counterparty risk and Incentives: Not yet an analysis of transaction costs ◮ Thompson (2010), Bias, Heider and Heorova (2011), Stephens and Thompson (2011) Eric Stephens and James R. Thompson School of Accounting and Finance, University of Waterloo Who Participates in Risk Transfer Markets? The Role of Transaction Costs and Counterparty Risk 8 / 37
Model Setup Perfect Information Asymmetric Info - Seller Quality Asymmetric Info - Underlying Risk Transaction Tax Literature • Transaction costs: Focuses on demand, prices and volatility. ◮ e.g., Vayanos (1998), Vayanos and Vila (1999), Lo, Mamaysky and Wang (2005) • Counterparty risk and Incentives: Not yet an analysis of transaction costs ◮ Thompson (2010), Bias, Heider and Heorova (2011), Stephens and Thompson (2011) Eric Stephens and James R. Thompson School of Accounting and Finance, University of Waterloo Who Participates in Risk Transfer Markets? The Role of Transaction Costs and Counterparty Risk 8 / 37
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