Risk Spillovers and Hedging: Why do firms invest too much in systemic risk?

Abstract

In this paper we show that free entry decisions may be socially ineffcient, 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 underinvest in technologies that would reduce systemic sector risk, and may overinvest 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 effciency.