Risk Spillovers and Hedging: Why Do Firms Invest Too Much in Systemic Risk
CentER Discussion Paper No. 2011-057
22 Pages Posted: 1 Jun 2011
Date Written: May 23, 2011
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.
Keywords: investments in productive assets, hedging, systemic risk, risk spillovers
JEL Classification: L51, L97, H23, G11
Suggested Citation: Suggested Citation