News implying that a hedge is likely to be loss-making can undermine the risk-prevention incentives of the protection seller and generate counterparty risk, according to a European Central Bank paper, published on January 10.

Bruno Biais, Florian Heider and Marie Hoerova, the paper's authors, study hedging in an optimal contracting framework to examine whether a moral hazard problem arises when protection sellers find out their position is likely to be loss-making. The authors argue that while