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

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  • Willems, Bert

    (Tilburg University, Center For Economic Research)

  • Morbee, J.

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 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 efficiency. We therefore believe that sectors without well-developed financial markets will benefit from sector-specific regulation of investment decisions.
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Suggested Citation

  • Willems, Bert & Morbee, J., 2011. "Risk Spillovers and Hedging : Why Do Firms Invest Too Much in Systemic Risk?," Discussion Paper 2011-057, Tilburg University, Center for Economic Research.
    • Handle: RePEc:tiu:tiucen:6b549d1a-062f-4595-bdb3-dcefc141a023
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    References listed on IDEAS

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    1. Schmalensee, Richard, 1981. "Economies of Scale and Barriers to Entry," Journal of Political Economy, University of Chicago Press, vol. 89(6), pages 1228-1238, December.
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    6. Willems, Bert & Morbee, Joris, 2010. "Market completeness: How options affect hedging and investments in the electricity sector," Energy Economics, Elsevier, vol. 32(4), pages 786-795, July.
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    More about this item

    Keywords

    investments in productive assets; hedging; systemic risk; risk spillovers;
    All these keywords.

    JEL classification:

    • L51 - Industrial Organization - - Regulation and Industrial Policy - - - Economics of Regulation
    • L97 - Industrial Organization - - Industry Studies: Transportation and Utilities - - - Utilities: General
    • H23 - Public Economics - - Taxation, Subsidies, and Revenue - - - Externalities; Redistributive Effects; Environmental Taxes and Subsidies
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions

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