Risk-Sharing, Investment, and Asset Prices According to Cournot and Arrow-Debreu
65 Pages Posted: 24 Jan 2019 Last revised: 10 Feb 2020
Date Written: August 7, 2019
We provide a framework for analyzing how large traders with price impact (such as banks) affect risk-sharing, capital allocation, and asset prices in a production economy with complete security markets. The central mechanism is that privately-optimal quantity distortions raise the cost of insuring idiosyncratic risk. This has effects consistent with recent macroeconomic trends: aggregate investment falls relative to the competitive benchmark, there is cross-sectional capital misallocation that lowers TFP, and the risk-free rate and the risk premium may both be compressed. Price impact is particularly distortionary when idiosyncratic risk is high, such as in recessions, and the exertion of market power can induce unexploited arbitrage opportunities. Distortions are strategic complements among sellers, but substitutes among buyers, generating upward pressure on asset prices. We provide a numerical illustration based on empirical measures of price impact.
Keywords: risk-sharing, market power, asset prices, investment, productivity, financial intermediaries, concentrated financial markets, price impact,
JEL Classification: E22, E44, G11, G12, G20
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