Risk-Sharing, Investment, and Asset Prices According to Cournot and Arrow-Debreu
66 Pages Posted: 24 Jan 2019 Last revised: 30 Mar 2020
Date Written: August 7, 2019
We provide a tractable framework for analyzing how large traders with price impact affect risk-sharing, capital allocation, and asset prices in a production economy with complete security markets. Our approach offers a novel characterization of strategic interactions under non-linear price impact, and provides simple formulas for measuring the welfare cost of strategic trading. The central economic mechanism is that privately-optimal quantity distortions raise the cost of insuring idiosyncratic risk, giving rise to a novel strategic externality. This has real effects consistent with recent macroeconomic trends: aggregate investment falls relative to the competitive benchmark, there is cross-sectional misallocation that lowers TFP, and there is a simultaneous compression of the risk-free rate and the risk premium. Comparative statics show price impact is particularly distortionary when idiosyncratic risk is high and risk attitudes are dispersed, as in recessions.
Keywords: risk-sharing, market power, asset prices, investment, productivity, financial intermediaries, concentrated financial markets, price impact,
JEL Classification: E22, E44, G11, G12, G20
Suggested Citation: Suggested Citation