Effective risk aversion in thin risk-sharing markets

TL;DR

This paper analyzes strategic behavior in thin, incomplete financial markets, showing how traders' risk exposures influence demand elasticity, leading to noncompetitive equilibria with efficiency losses but potential utility gains for certain traders.

Contribution

It introduces a model of strategic demand submission in thin markets, providing conditions for equilibrium existence and analyzing the impact of risk exposure on market outcomes.

Findings

Risk-exposed traders submit more elastic demand functions.

Noncompetitive equilibria differ from competitive ones, often reducing social efficiency.

High risk tolerance traders gain more utility in noncompetitive settings.

Abstract

We consider thin incomplete financial markets, where traders with heterogeneous preferences and risk exposures have motive to behave strategically regarding the demand schedules they submit, thereby impacting prices and allocations. We argue that traders relatively more exposed to market risk tend to submit more elastic demand functions. Noncompetitive equilibrium prices and allocations result as an outcome of a game among traders. General sufficient conditions for existence and uniqueness of such equilibrium are provided, with an extensive analysis of two-trader transactions. Even though strategic behaviour causes inefficient social allocations, traders with sufficiently high risk tolerance and/or large initial exposure to market risk obtain more utility gain in the noncompetitive equilibrium, when compared to the competitive one.