Risk Spillovers and Hedging: Why Do Firms Invest Too Much in Systemic Risk
Tilburg University - Department of Economics - CentER & TILEC
Catholic University of Leuven (KUL) - Center for Economic Studies and Energy Institute
May 23, 2011
CentER Discussion Paper No. 2011-057
TILEC Discussion Paper No. 2011-029
In this paper we show that free entry decisions may be socially inefficient, even in a perfectly competitive homogeneous goods market with non-lumpy investments. In our model, inefficient entry decisions are the result of risk-aversion of incumbent producers and consumers, combined with incomplete financial markets which limit risk-sharing between market actors. Investments in productive assets affect the distribution of equilibrium prices and quantities, and create risk spillovers. From a societal perspective, entrants under-invest in technologies that would reduce systemic sector risk, and may over-invest in risk-increasing technologies. The inefficiency is shown to disappear when a complete financial market of tradable risk-sharing instruments is available, although the introduction of any individual tradable instrument may actually decrease efficiency. We therefore believe that sectors without well-developed financial markets will benefit from sector-specific regulation of investment decisions.
Number of Pages in PDF File: 22
Keywords: investments in productive assets, hedging, systemic risk, risk spillovers
JEL Classification: L51, L97, H23, G11
Date posted: June 1, 2011
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