We analyze optimal hedging contracts and show that although hedging aims at sharing risk, it can lead to more risk …-taking. News implying that a hedge is likely to be loss-making undermines the risk-prevention incentives of the protection seller …. This incentive problem limits the capacity to share risks and generates endogenous counterparty risk. Optimal hedging can …

Derivatives activity, motivated by risk-sharing, can breed risk-taking. Bad news about the risk of the asset underlying … the derivative increases the expected liability of a protection seller and undermines her risk-prevention incentives. This … limits risk-sharing, and may create endogenous counterparty risk and contagion from news about the hedged risk to the balance …