Risk Spillovers and Hedging: Why Do Firms Invest Too Much in Systemic Risk?

23 Pages Posted: 23 Sep 2011

See all articles by Bert Willems

Bert Willems

UCLouvain - LIDAM / CORE; Tilburg University - Department of Economics - CentER & TILEC; University of Toulouse 1 - Toulouse School of Economics (TSE)

Joris Morbee

Catholic University of Leuven (KUL) - Center for Economic Studies and Energy Institute

Date Written: May 13, 2011

Abstract

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 underinvest in technologies that would reduce systemic sector risk, and may overinvest 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 tradeable instrument may actually decrease efficiency. We therefore believe that sectors without well-developed financial markets will benefit from sector-specific regulation of investment decisions.

Suggested Citation

Willems, Bert and Morbee, Joris, Risk Spillovers and Hedging: Why Do Firms Invest Too Much in Systemic Risk? (May 13, 2011). Available at SSRN: https://ssrn.com/abstract=1932560 or http://dx.doi.org/10.2139/ssrn.1932560

Bert Willems (Contact Author)

UCLouvain - LIDAM / CORE ( email )

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Joris Morbee

Catholic University of Leuven (KUL) - Center for Economic Studies and Energy Institute ( email )

Belgium

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