The Insurance Is the Lemon: Failing to Index Contracts
43 Pages Posted: 5 Oct 2017
Date Written: October 3, 2017
We introduce a model to explain the widespread failure of financial contracts to efficiently share risk by conditioning on public indices. In our model, a borrower seeks financing for a project from a set of lenders. The borrower and lenders can share risk by conditioning repayments on an index. However, the lenders have private information about the ability of this index to measure the true underlying state the borrower would like to hedge. If a lender makes an offer that features higher repayments in “good” states, in exchange for lower repayments in “bad” states, she must ask for higher average repayments, because the lender is exposed to these risks. The borrower, however, is concerned that she is paying something for nothing; if the index is a poor measure of the true underlying state, the cost of this contract might exceed its benefits. We provide conditions under which this effect is strong enough to cause the borrower to reject this contract, and choose a conventional, non-contingent contract instead. Under these conditions, many equilibria are possible, and the equilibrium in which the agents use a non-contingent contract is ex-ante Pareto-inferior to an equilibrium in which they employ the index.
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