The Insurance Is the Lemon: Failing to Index Contracts

43 Pages Posted: 5 Oct 2017

See all articles by Barney Hartman-Glaser

Barney Hartman-Glaser

University of California, Los Angeles (UCLA) - Anderson School of Management

Benjamin Hebert

Stanford University

Date Written: October 3, 2017

Abstract

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.

Suggested Citation

Hartman-Glaser, Barney and Hebert, Benjamin M., The Insurance Is the Lemon: Failing to Index Contracts (October 3, 2017). Available at SSRN: https://ssrn.com/abstract=3048100 or http://dx.doi.org/10.2139/ssrn.3048100

Barney Hartman-Glaser

University of California, Los Angeles (UCLA) - Anderson School of Management ( email )

110 Westwood Plaza
Los Angeles, CA 90095-1481
United States

Benjamin M. Hebert (Contact Author)

Stanford University ( email )

Stanford, CA 94305
United States

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