Risk Sharing, Investment Efficiency, and Welfare with Feedback Effects

52 Pages Posted: 20 Apr 2021 Last revised: 29 Jun 2021

See all articles by Snehal Banerjee

Snehal Banerjee

University of California, San Diego (UCSD) - Rady School of Management

Bradyn M. Breon-Drish

University of California, San Diego (UCSD) - Rady School of Management

Kevin Smith

Stanford University Graduate School of Business

Date Written: June 28, 2021

Abstract

Financial markets enable risk sharing and efficient allocation of capital. We characterize how these roles interact in a “feedback effects” model with diversely informed, risk-averse investors and a manager who learns from prices when making an investment decision. While learning from prices always improves investment efficiency, we identify a novel channel by which it can reduce welfare. Namely, investment decisions change the stock’s exposure to underlying shocks and, consequently, investors’ ability to hedge risk. We show that this is a robust feature of general investment decisions, and outline implications for firm governance and policy.

Keywords: feedback effect, welfare, investment efficiency, hedging, market completeness

JEL Classification: D82, D84, G12, G14

Suggested Citation

Banerjee, Snehal and Breon-Drish, Bradyn M. and Smith, Kevin, Risk Sharing, Investment Efficiency, and Welfare with Feedback Effects (June 28, 2021). Available at SSRN: https://ssrn.com/abstract=3825025 or http://dx.doi.org/10.2139/ssrn.3825025

Snehal Banerjee (Contact Author)

University of California, San Diego (UCSD) - Rady School of Management ( email )

9500 Gilman Drive
Rady School of Management
La Jolla, CA 92093
United States

Bradyn M. Breon-Drish

University of California, San Diego (UCSD) - Rady School of Management ( email )

9500 Gilman Drive
Rady School of Management
La Jolla, CA 92093
United States

Kevin Smith

Stanford University Graduate School of Business ( email )

655 Knight Way
Stanford, CA 94305-5015
United States

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