Risk Spillovers and Hedging: Why Do Firms Invest Too Much in Systemic Risk?

Bert Willems, J. Morbee

Research output: Working paperDiscussion paperOther research output

Abstract

In this paper we show that free entry decisions may be socially inefficient, even in a perfectly competitive homogeneous goods market with non-lumpy investments. In our model, inefficient entry decisions are the result of risk-aversion of incumbent producers and consumers, combined with incomplete financial markets which limit risk-sharing between market actors. Investments in productive assets affect the distribution of equilibrium prices and quantities, and create risk spillovers. From a societal perspective, entrants under-invest in technologies that would reduce systemic sector risk, and may over-invest in risk-increasing technologies. The inefficiency is shown to disappear when a complete financial market of tradable risk-sharing instruments is available, although the introduction of any individual tradable instrument may actually decrease efficiency. We therefore believe that sectors without well-developed financial markets will benefit from sector-specific regulation of investment decisions.
Original languageEnglish
Place of PublicationTilburg
PublisherTILEC
Volume2011-029
Publication statusPublished - 2011

Publication series

NameTILEC Discussion Paper
Volume2011-029

Keywords

  • investments in productive assets
  • hedging
  • systemic risk
  • risk spillovers

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