Effective risk aversion in thin risk-sharing markets
Michail Anthropelos
Department of Banking and Financial Management, University of Piraeus, Piraeus, Athens, Greece
Search for more papers by this authorCorresponding Author
Constantinos Kardaras
Statistics Department, London School of Economics and Political Science, London, UK
Correspondence
Constantinos Kardaras, Statistics Department, London School of Economics and Political Science, London, UK.
Email: k.kardaras@lse.ac.uk
Search for more papers by this authorGeorgios Vichos
Statistics Department, London School of Economics and Political Science, London, UK
Search for more papers by this authorMichail Anthropelos
Department of Banking and Financial Management, University of Piraeus, Piraeus, Athens, Greece
Search for more papers by this authorCorresponding Author
Constantinos Kardaras
Statistics Department, London School of Economics and Political Science, London, UK
Correspondence
Constantinos Kardaras, Statistics Department, London School of Economics and Political Science, London, UK.
Email: k.kardaras@lse.ac.uk
Search for more papers by this authorGeorgios Vichos
Statistics Department, London School of Economics and Political Science, London, UK
Search for more papers by this authorAbstract
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 the market portfolio tend to behave in a more risk tolerant manner. 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 extensive analysis of two-trader transactions. Even though strategic behavior causes inefficient social allocations, traders with sufficiently high risk tolerance and/or high initial exposure to tradable securities obtain more utility gain in the noncompetitive equilibrium, when compared to the competitive one.
REFERENCES
- Amir, R., Erickson, P., & Jin, J. (2017). On the microeconomic foundations of linear demand for differentiated products. Journal of Economic Theory, 169, 641–665.
- Anthropelos, M. (2017). The effect of market power on risk-sharing. Mathematics and Financial Economics, 11, 323–368.
- Anthropelos, M., & Kardaras, C. (2017). Equilibrium in risk-sharing games. Finance and Stochastics, 21(3), 815–865.
- Anthropelos, M., & Žitković, G. (2010). On agent's agreement and partial-equilibrium pricing in incomplete markets. Mathematical Finance, 20(3), 411–446.
- Babus, A. (2016). The formation of financial networks. RAND Journal of Economics, 47, 239–272.
- Babus, A., & Hu, T.-W. (2017). Endogenous intermediation in over-the-counter markets. Journal of Financial Economics, 125(1), 200–215.
- Back, K. (1992). Insider trading in continuous time. The Review of Financial Studies, 5(3), 387–409.
- Back, K., Cao, C., & Willard, G. (2000). Imperfect competition among informed traders. The Journal of Finance, 55(5), 2117–2155.
- Barrieu, P., & El Karoui, N. (2005). Inf-convolution of risk measures and optimal risk transfer. Finance and Stochastics, 9(2), 269–298.
- Blume, M., & Keim, D. (2012). Institutional investors and stock market liquidity: Trends and relationships. SSRN Working Paper.
- Borch, K. (1962). Equilibrium in a re-insurance market. Econometrica, 30, 424–444.
- Brunnermeier, M., & Pedersen, L. (2005). Predatory trading. Journal of Finance, 60, 1825–1863.
- Buhlmann, H. (1984). The general economic principle premium. Astin Bulletin, 14, 13–21.
10.1017/S0515036100004773 Google Scholar
- Duffie, D., Gârleanu, N., & Pedersen, L. (2007). Valuation in over-the-counter markets. Review of Financial Studies, 20(6), 1865–1900.
- Duffie, D., Scheicher, M., & Vuillemey, G. (2015). Central clearing and collateral demand. Journal of Financial Economics, 116, 237–256.
- Gibson, S., Singh, R., & Yerramilli, V. (2003). The effect of decimalization on the components of the bid-ask spread. Journal of Financial Intermediation, 12, 121–148.
- Hameed, A., Lof, M., & Suominen, M. (2017). Slow trading and stock return predictability. Working Paper, available at SSRN: https://ssrn.com/abstract=2671237.
- Hendershott, T., & Madhavan, A. (2015). Click or call? Auction versus search in the over-the-counter market. Journal of Finance, 70, 419–447.
- Jouini, E., Schachermayer, W., & Touzi, N. (2008). Optimal risk sharing for law invariant monetary utility functions. Mathematical Finance, 18(2), 269–292.
- Keim, D., & Madhavan, M. (1995). The anatomy of the trading process: Empirical evidence on the behavior of institutional traders. Journal of Financial Economics, 37, 371–398.
- Keim, D., & Madhavan, M. (1996). The upstairs markets for large-block transactions. analyses and measurement of price effects. Review of Financial Studies, 9, 1–39.
- Klemperer, P., & Meyer, M. (1989). Supply function equilibria in oligopoly under uncertainty. Econometrica, 57(6), 1243–1277.
- Kyle, A. (1989). Informed speculation with imperfect competition. Review of Economic Studies, 56(3), 317–55.
- Kyle, A., Obizhaeva, A., & Wang, Y. (2018). Smooth trading with overconfidence and market power. The Review of Economic Studies, 85(1), 611–662.
- Liu, H., & Wang, Y. (2016). Market making with asymmetric information and inventory risk. Journal of Economic Theory, 163, 73–109.
- Madhavan, M., & Cheng, M. (1997). In search of liquidity: Block trades in the upstairs and downstairs markets. Review of Financial Studies, 10, 175–203.
- Magill, M., & Quinzii, M. (2002). Theory of incomplete markets (Vol. 1). Cambridge, MA: MIT Press.
- Malamud, S., & Rostek, M. (2017). Decentralized exchange. Americal Economic Review, 11, 3320–3362.
- Robertson, S. (2017). Pricing for large positions in contingent claims. Mathematical Finance, 27(3), 746–778.
- Rostek, M., & Weretka, M. (2008). Thin markets. In S. N. Durlauf & L. E. Blume (Eds.), The new Palgrave dictionary of economics online (pp. 307–336). London: Palgrave Macmillan.
- Rostek, M., & Weretka, M. (2012). Price inference in small markets. Econometrica, 80(2), 687–711.
- Rostek, M., & Weretka, M. (2015). Dynamic thin markets. Review of Financial Studies, 28, 2946–2992.
- Vayanos, D. (1999). Strategic trading and welfare in a dynamic market. Review of Economic Studies, 66(2), 219–54.
- Vives, X. (2011). Strategic supply function competition with private information. Econometrica, 79, 1919–1966.
- Weretka, M. (2011). Endogenous market power. Journal of Economic Theory, 146(6), 2281–2306.
- Zawadowski, A. (2013). Entangled financial systems. Review of Financial Studies, 26(1), 1291–1323.