Who Participates in Risk Transfer Markets? The Role of Transaction - - PowerPoint PPT Presentation

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

Model Setup Perfect Information Asymmetric Info - Seller Quality Asymmetric Info - Underlying Risk Transaction Tax

Speculation versus Hedging

• Risk aversion: Keynes (1930) and Hicks (1946)
• Risk aversion + beliefs: Hirshleifer (1975, 1977), Spiegel and

Subrahmanyam (1992) etc...

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 9 / 37

Model Setup Perfect Information Asymmetric Info - Seller Quality Asymmetric Info - Underlying Risk Transaction Tax

Speculation versus Hedging

• Risk aversion: Keynes (1930) and Hicks (1946)
• Risk aversion + beliefs: Hirshleifer (1975, 1977), Spiegel and

Subrahmanyam (1992) etc...

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 9 / 37

Model Setup Perfect Information Asymmetric Info - Seller Quality Asymmetric Info - Underlying Risk Transaction Tax

Players

• Measure Z of buyers: heterogenous in preferences/aversion to

risk.

◮ Endowed with the same risk (e.g., credit risk).

• Two seller types

◮ Either ’(G)ood’ or ’(B)ad’ ◮ Both have investment opportunity and exogenous probability

• f default.

◮ Assume N > Z of each type. 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 10 / 37

Model Setup Perfect Information Asymmetric Info - Seller Quality Asymmetric Info - Underlying Risk Transaction Tax

Players

• Measure Z of buyers: heterogenous in preferences/aversion to

risk.

◮ Endowed with the same risk (e.g., credit risk).

• Two seller types

◮ Either ’(G)ood’ or ’(B)ad’ ◮ Both have investment opportunity and exogenous probability

• f default.

◮ Assume N > Z of each type. 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 10 / 37

Model Setup Perfect Information Asymmetric Info - Seller Quality Asymmetric Info - Underlying Risk Transaction Tax

Buyers

• Risk to be transferred. “Asset” returns RB with probability p,

nothing otherwise

• Transfers unit 1 worth of risk at a cost of PG or PB.
• Suffer cost Zi if no protection, or if protection and

counterparty fails to pay.

• Measure of buyers on [0, Z].
• Each buyers contracts with a unique seller.

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 11 / 37

Model Setup Perfect Information Asymmetric Info - Seller Quality Asymmetric Info - Underlying Risk Transaction Tax

Buyers

• Risk to be transferred. “Asset” returns RB with probability p,

nothing otherwise

• Transfers unit 1 worth of risk at a cost of PG or PB.
• Suffer cost Zi if no protection, or if protection and

counterparty fails to pay.

• Measure of buyers on [0, Z].
• Each buyers contracts with a unique seller.

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 11 / 37

Model Setup Perfect Information Asymmetric Info - Seller Quality Asymmetric Info - Underlying Risk Transaction Tax

Buyers

• Risk to be transferred. “Asset” returns RB with probability p,

nothing otherwise

• Transfers unit 1 worth of risk at a cost of PG or PB.
• Suffer cost Zi if no protection, or if protection and

counterparty fails to pay.

• Measure of buyers on [0, Z].
• Each buyers contracts with a unique seller.

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 11 / 37

Model Setup Perfect Information Asymmetric Info - Seller Quality Asymmetric Info - Underlying Risk Transaction Tax

Buyers

• Risk to be transferred. “Asset” returns RB with probability p,

nothing otherwise

• Transfers unit 1 worth of risk at a cost of PG or PB.
• Suffer cost Zi if no protection, or if protection and

counterparty fails to pay.

• Measure of buyers on [0, Z].
• Each buyers contracts with a unique seller.

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 11 / 37

Model Setup Perfect Information Asymmetric Info - Seller Quality Asymmetric Info - Underlying Risk Transaction Tax

Buyers

• Risk to be transferred. “Asset” returns RB with probability p,

nothing otherwise

• Transfers unit 1 worth of risk at a cost of PG or PB.
• Suffer cost Zi if no protection, or if protection and

counterparty fails to pay.

• Measure of buyers on [0, Z].
• Each buyers contracts with a unique seller.

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 11 / 37

Model Setup Perfect Information Asymmetric Info - Seller Quality Asymmetric Info - Underlying Risk Transaction Tax

Good Sellers

• Receive payment PG.
• Invests payment at rate of return 1 + rG.
• Exogenous probability of default 1 − qG.

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 12 / 37

Model Setup Perfect Information Asymmetric Info - Seller Quality Asymmetric Info - Underlying Risk Transaction Tax

Good Sellers

• Receive payment PG.
• Invests payment at rate of return 1 + rG.
• Exogenous probability of default 1 − qG.

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 12 / 37

Model Setup Perfect Information Asymmetric Info - Seller Quality Asymmetric Info - Underlying Risk Transaction Tax

Good Sellers

• Receive payment PG.
• Invests payment at rate of return 1 + rG.
• Exogenous probability of default 1 − qG.

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 12 / 37

Model Setup Perfect Information Asymmetric Info - Seller Quality Asymmetric Info - Underlying Risk Transaction Tax

Bad Sellers

• Receives payment PB.
• Invests payment at rate 1 + rB.
• Exogenous probability of default 1 − qB. Assume rG < rB and

qG > qB.

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 13 / 37

Model Setup Perfect Information Asymmetric Info - Seller Quality Asymmetric Info - Underlying Risk Transaction Tax

Bad Sellers

• Receives payment PB.
• Invests payment at rate 1 + rB.
• Exogenous probability of default 1 − qB. Assume rG < rB and

qG > qB.

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 13 / 37

Model Setup Perfect Information Asymmetric Info - Seller Quality Asymmetric Info - Underlying Risk Transaction Tax

Bad Sellers

• Receives payment PB.
• Invests payment at rate 1 + rB.
• Exogenous probability of default 1 − qB. Assume rG < rB and

qG > qB.

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 13 / 37

Model Setup Perfect Information Asymmetric Info - Seller Quality Asymmetric Info - Underlying Risk Transaction Tax

Transaction Costs and prices

• Each Transaction incurs the cost ∆.
• With perfect info: buyers absorb cost.
• With perfect info: All sellers driven down to zero profit

P0

G > P0 B.

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 14 / 37

Model Setup Perfect Information Asymmetric Info - Seller Quality Asymmetric Info - Underlying Risk Transaction Tax

Transaction Costs and prices

• Each Transaction incurs the cost ∆.
• With perfect info: buyers absorb cost.
• With perfect info: All sellers driven down to zero profit

P0

G > P0 B.

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 14 / 37

Model Setup Perfect Information Asymmetric Info - Seller Quality Asymmetric Info - Underlying Risk Transaction Tax

Transaction Costs and prices

• Each Transaction incurs the cost ∆.
• With perfect info: buyers absorb cost.
• With perfect info: All sellers driven down to zero profit

P0

G > P0 B.

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 14 / 37

Model Setup Perfect Information Asymmetric Info - Seller Quality Asymmetric Info - Underlying Risk Transaction Tax

Payoffs

• Seller j (payoff from contract):

qj [p(1 + rj)Pj + (1 − p) ((1 + rj)Pj − 1)]

• Buyer i:

pRB + (1 − p)qj − (1 − p)(1 − qj)Zi − Pj − ∆.

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 15 / 37

Model Setup Perfect Information Asymmetric Info - Seller Quality Asymmetric Info - Underlying Risk Transaction Tax

Payoffs

• Seller j (payoff from contract):

qj [p(1 + rj)Pj + (1 − p) ((1 + rj)Pj − 1)]

• Buyer i:

pRB + (1 − p)qj − (1 − p)(1 − qj)Zi − Pj − ∆.

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 15 / 37

Model Setup Perfect Information Asymmetric Info - Seller Quality Asymmetric Info - Underlying Risk Transaction Tax

Equilibrium

Z = 0 Z = Z

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 16 / 37

Model Setup Perfect Information Asymmetric Info - Seller Quality Asymmetric Info - Underlying Risk Transaction Tax

Z = 0 Z = Z ˆ Z =

P 0

G−P 0 B

(1−p)(qG−qB) − 1

Prefers bad seller over good Prefers good seller over bad

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 17 / 37

Model Setup Perfect Information Asymmetric Info - Seller Quality Asymmetric Info - Underlying Risk Transaction Tax

Z = 0 Z = Z ZB =

P 0

B+∆

qB(1−p) − 1

Not in Market Contract with bad seller Contract with good seller ˆ Z

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 18 / 37

Model Setup Perfect Information Asymmetric Info - Seller Quality Asymmetric Info - Underlying Risk Transaction Tax

Counterparty Risk

Proposition

The effect of transaction costs on the composition of sellers in the market is characterized as follows:

• 1. When ∆ > (1 + Z)(1 − p)qG − P0

G, there is no market for risk

transfer.

• 2. When (P0

G −P0 B)qG

qG −qB

− P0

G ≤ ∆ ≤ (1 + Z)(1 − p)qG − P0 G, only

good sellers exist in the market.

• 3. When ∆ < (P0

G −P0 B)qG

qG −qB

− P0

G, both good and bad sellers exist

in the 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 19 / 37

Model Setup Perfect Information Asymmetric Info - Seller Quality Asymmetric Info - Underlying Risk Transaction Tax

∆H > (1 + Z)(1 − p)qG − P0

G Z = 0 Not in Market ˆ Z Z = Z Z(∆H)

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 20 / 37

Model Setup Perfect Information Asymmetric Info - Seller Quality Asymmetric Info - Underlying Risk Transaction Tax

(P0

G −P0 B)qG

qG −qB

− P0

G ≤ ∆M ≤ (1 + Z)(1 − p)qG − P0 G Z = 0 Not in Market Z = Z Z(∆M) Contract with good seller ˆ Z

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 21 / 37

Model Setup Perfect Information Asymmetric Info - Seller Quality Asymmetric Info - Underlying Risk Transaction Tax

∆L < (P0

G −P0 B)qG

qG −qB

− P0

G Z = 0 Z = Z Not in Market Contract with bad seller Contract with good seller ˆ Z Z(∆L)

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 22 / 37

Model Setup Perfect Information Asymmetric Info - Seller Quality Asymmetric Info - Underlying Risk Transaction Tax

Counterparty Risk

Corollary

• 1. When ∆ ≤ (1 + Z)(1 − p)qG − P0

G (i.e. when a market

exists), risk transfer increases as transaction costs decrease.

• 2. When ∆ < (P0

G −P0 B)qG

qG −qB

− P0

G (i.e. when both types of seller are

active), the relative number of bad sellers increases as transaction costs decrease.

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 23 / 37

Model Setup Perfect Information Asymmetric Info - Seller Quality Asymmetric Info - Underlying Risk Transaction Tax

• Assume that φN bad sellers can pool with good sellers,

(1 − φ)N bad sellers revealed ex-ante.

• Those not revealed can charge P∗

B = P0 G > P0 B.

• Assume ∆ < (1 + Z)(1 − p)qG − PG

0 - There exists a market

with perfect info.

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 24 / 37

Model Setup Perfect Information Asymmetric Info - Seller Quality Asymmetric Info - Underlying Risk Transaction Tax

• Assume that φN bad sellers can pool with good sellers,

(1 − φ)N bad sellers revealed ex-ante.

• Those not revealed can charge P∗

B = P0 G > P0 B.

• Assume ∆ < (1 + Z)(1 − p)qG − PG

0 - There exists a market

with perfect info.

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 24 / 37

Model Setup Perfect Information Asymmetric Info - Seller Quality Asymmetric Info - Underlying Risk Transaction Tax

• Assume that φN bad sellers can pool with good sellers,

(1 − φ)N bad sellers revealed ex-ante.

• Those not revealed can charge P∗

B = P0 G > P0 B.

• Assume ∆ < (1 + Z)(1 − p)qG − PG

0 - There exists a market

with perfect info.

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 24 / 37

Model Setup Perfect Information Asymmetric Info - Seller Quality Asymmetric Info - Underlying Risk Transaction Tax

Market Collapse - High Transaction Costs

Proposition

When (1 + Z)(1 − p) φqB+qG

1+φ

− PG

0 < ∆ < (1 + Z)(1 − p)qG − PG

the market collapses in the presence of asymmetric information of seller quality.

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 25 / 37

Model Setup Perfect Information Asymmetric Info - Seller Quality Asymmetric Info - Underlying Risk Transaction Tax

Assume that with perfect info...

Z = 0 Z = Z Contract with good seller ˆ Z Z Not in 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 26 / 37

Model Setup Perfect Information Asymmetric Info - Seller Quality Asymmetric Info - Underlying Risk Transaction Tax

Now with asymmetric info...

Z = 0 ˆ Z Z Not in Market ˆ Zpool Z = Z = Zpool

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 27 / 37

Model Setup Perfect Information Asymmetric Info - Seller Quality Asymmetric Info - Underlying Risk Transaction Tax

Low Transaction Costs

• Revealed bad sellers charge P∗

B ≥ P0 B.

• Result:

◮ If N(1 − φ) sufficiently small, can charge P∗

B > P0 B

◮ Else, charge P∗

B = PB

• Properties of P∗

B

◮ P∗

B < P0 G

◮

dP∗

B

dφ > 0

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 28 / 37

Model Setup Perfect Information Asymmetric Info - Seller Quality Asymmetric Info - Underlying Risk Transaction Tax

Low Transaction Costs

• Revealed bad sellers charge P∗

B ≥ P0 B.

• Result:

◮ If N(1 − φ) sufficiently small, can charge P∗

B > P0 B

◮ Else, charge P∗

B = PB

• Properties of P∗

B

◮ P∗

B < P0 G

◮

dP∗

B

dφ > 0

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 28 / 37

Model Setup Perfect Information Asymmetric Info - Seller Quality Asymmetric Info - Underlying Risk Transaction Tax

Low Transaction Costs

• Revealed bad sellers charge P∗

B ≥ P0 B.

• Result:

◮ If N(1 − φ) sufficiently small, can charge P∗

B > P0 B

◮ Else, charge P∗

B = PB

• Properties of P∗

B

◮ P∗

B < P0 G

◮

dP∗

B

dφ > 0

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 28 / 37

Model Setup Perfect Information Asymmetric Info - Seller Quality Asymmetric Info - Underlying Risk Transaction Tax

Incentive to Reveal

• If P∗

B is high, pooling bad sellers may wish to reveal.

Lemma

There exists a φ = φ such that: (1 + rB)P∗

B(φ) − (1 − p) = Z − ˆ

Zpl(P∗

B)

N(1 + φ)

• (1 + rB)P0

G − (1 − p)

• .

When φ > φ ex-ante, pooling bad sellers reveal such that φ = φ ex-post.

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 29 / 37

Model Setup Perfect Information Asymmetric Info - Seller Quality Asymmetric Info - Underlying Risk Transaction Tax

Counterparty Risk

Proposition

• 1. There are ˆ

Zpool − ˆ Z buyers that contract with the good seller with perfect information but chose the bad over the pool with asymmetric information.

• 2. There are Z(P∗

B) − Z(P0 B) buyers that contract with the bad

seller with perfect information but drop out of the market with asymmetric information. If there are sufficiently many revealed bad sellers, Z(P∗

B) − Z B(P0 B) = 0 and the first effect (i) dominates the second

(ii).

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 30 / 37

Model Setup Perfect Information Asymmetric Info - Seller Quality Asymmetric Info - Underlying Risk Transaction Tax

With perfect info...

Z = 0 ˆ Z Z = Z Z(P 0

B)

Contract with bad seller Contract with Good seller Not in 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 31 / 37

Model Setup Perfect Information Asymmetric Info - Seller Quality Asymmetric Info - Underlying Risk Transaction Tax

With asymmetric info: high φ

Z = 0 ˆ Z Z = Z Z(P 0

B)

Contract with bad seller Not in Market Z(P ∗

B)

ˆ Zpool(P ∗

B)

Contract with pool

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 32 / 37

Model Setup Perfect Information Asymmetric Info - Seller Quality Asymmetric Info - Underlying Risk Transaction Tax

With asymmetric info: as φ decreases...

Z = 0 ˆ Z Z = Z Z(P 0

B) Z(P ∗ B)

ˆ Zpool(P ∗

B)

Increase in bad sellers Decrease in bad sellers

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 33 / 37

Model Setup Perfect Information Asymmetric Info - Seller Quality Asymmetric Info - Underlying Risk Transaction Tax

With asymmetric info: as φ decreases...

Z = 0 ˆ Z Z = Z Z(P 0

B) Z(P ∗ B)

ˆ Zpool(P ∗

B)

Increase in bad sellers Decrease in bad sellers

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 34 / 37

Model Setup Perfect Information Asymmetric Info - Seller Quality Asymmetric Info - Underlying Risk Transaction Tax

With asymmetric info: φ sufficiently small...

Z = 0 ˆ Z Z = Z Z(P 0

B)

ˆ Zpool(P 0

B)

Increase in bad sellers

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 35 / 37

Model Setup Perfect Information Asymmetric Info - Seller Quality Asymmetric Info - Underlying Risk Transaction Tax

Asymmetric info - Underlying Risk

• Let there be two types of risks (buyers): (S)afe and (R)isky
• Assume buyers distributed on [0, Z] for both risks
• Assume only one seller type (qB = qG = q).

Proposition

When transaction costs are high, ∆ ≥ (1 + Z S)(1 − pS)q − P((1 − pR), asymmetric information cannot exist in the market. When ∆ < (1 + Z S)(1 − pS)q − P((1 − pR)) there exists a unique equilibrium in which risk transfer can occur with asymmetric information.

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 36 / 37

Model Setup Perfect Information Asymmetric Info - Seller Quality Asymmetric Info - Underlying Risk Transaction Tax

Asymmetric info - Underlying Risk

• Let there be two types of risks (buyers): (S)afe and (R)isky
• Assume buyers distributed on [0, Z] for both risks
• Assume only one seller type (qB = qG = q).

Proposition

When transaction costs are high, ∆ ≥ (1 + Z S)(1 − pS)q − P((1 − pR), asymmetric information cannot exist in the market. When ∆ < (1 + Z S)(1 − pS)q − P((1 − pR)) there exists a unique equilibrium in which risk transfer can occur with asymmetric information.

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 36 / 37

Model Setup Perfect Information Asymmetric Info - Seller Quality Asymmetric Info - Underlying Risk Transaction Tax

Asymmetric info - Underlying Risk

• Let there be two types of risks (buyers): (S)afe and (R)isky
• Assume buyers distributed on [0, Z] for both risks
• Assume only one seller type (qB = qG = q).

Proposition

When transaction costs are high, ∆ ≥ (1 + Z S)(1 − pS)q − P((1 − pR), asymmetric information cannot exist in the market. When ∆ < (1 + Z S)(1 − pS)q − P((1 − pR)) there exists a unique equilibrium in which risk transfer can occur with asymmetric information.

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 36 / 37

Model Setup Perfect Information Asymmetric Info - Seller Quality Asymmetric Info - Underlying Risk Transaction Tax

Transaction Tax / Conclusion

Proposition

The introduction of a transaction tax (i.e., an increase in transaction costs):

• 1. Reduces speculation.
• 2. Reduces the information rent that can be extracted when

there is asymmetric information on seller quality or underlying asset quality.

• 3. Reduces risk transfer and in extreme cases can cause the

market to collapse.

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 37 / 37