The Effect of Market Power on Risk-Sharing

TL;DR

This paper models how strategic behavior among financial agents in oligopolistic markets affects risk-sharing efficiency and pricing, revealing suboptimal securities and the role of risk aversion heterogeneity.

Contribution

It introduces a strategic equilibrium framework for risk-sharing in incomplete and complete markets, highlighting the impact of agents' strategic choices on securities and prices.

Findings

Risk-sharing securities are suboptimal at equilibrium.

Prices remain unaffected only when agents have identical risk aversion.

Lower risk-averse agents act as predatory traders, reducing efficiency.

Abstract

The paper studies an oligopolistic equilibrium model of financial agents who aim to share their random endowments. The risk-sharing securities and their prices are endogenously determined as the outcome of a strategic game played among all the participating agents. In the complete-market setting, each agent's set of strategic choices consists of the security payoffs and the pricing kernel that are consistent with the optimal-sharing rules; while in the incomplete setting, agents respond via demand functions on a vector of given tradeable securities. It is shown that at the (Nash) risk-sharing equilibrium, the sharing securities are suboptimal, since agents submit for sharing different risk exposures than their true endowments. On the other hand, the Nash equilibrium prices stay unaffected by the game only in the special case of agents with the same risk aversion. In addition, agents with sufficiently lower risk aversion act as predatory traders, since they absorb utility surplus from the high risk averse agents and reduce the efficiency of sharing. The main results of the paper also hold under the generalized models that allow the presence of noise traders and heterogeneity in agents' beliefs.