Information, Incentives, and Effects of Risk-Sharing on the Real Economy (Summary)

The mutuality principle states that when risks are diversifiable, each agent has the same consumption in each state of the world. In the Arrow–Debreu framework with no trading costs, every agent chooses their consumption for different states such that their consumption maximizes expected utility. Risk transfer impacts only individual agents, not the overall aggregate wealth. When all risks are diversifiable, risk pooling can occur and both the aggregate wealth and agents’ consumption is the same in every state—that is, agents hold a risk-free portfolio. In the perfect market, more risk is borne by more risk-tolerant agents, and the indemnity of one agent is the other agent’s potential loss. In practice, however, markets are not efficient and market frictions exist.

Diversification of market frictions is not costless for a number of reasons. For starters, there are transaction expenses. Furthermore, an agent’s actions can affect the aggregate wealth level, and insurance can result in excessive risk taking. In addition, banks might be tempted to lend to high-risk customers in their search of “reaching for yield.” Lastly, some risks, such as natural catastrophe risks, cannot be hedged.

Because of these market frictions, risk management actions have an impact on the real economy. Credit default swaps were designed to manage risks, but in practice, they are also used for speculation. This distinction also appears in the (commodity) futures market, where some users apply these instruments for risk mitigation while others use them for speculation. Also, political risk can result in market frictions; markets are impacted by human psychology (Keynes’s “animal spirits”); and market sentiments can result in market swings.

The authors look at literature on the Asia-Pacific region to assess which market frictions exist and what risk mitigation techniques are available to address them.

Risk identification relates to individual risks as well as how risk types interact. Research shows that credit risk can originate from a predetermined value (Merton), a default boundary, or rollover risk (the latter being the risk that short-term instruments are rolled over). Covenants are methods to limit credit risk. Systematic risk looks at the failure of the entire financial system, and banks play an important role with such indicators as size, leverage, and (non-performing) loans. Market views on banks can influence economic growth, and the authors show that short-term money flows, also called “hot money,” have a clear impact on the real economy. Inconsistency between regulatory frameworks allows for hot money flows in the insurance market.

Accurate risk estimation is key for correct risk response, and Monte Carlo simulation or iteration procedures are effective for appropriate risk assessment.

Once risks are identified and measured, they need to be managed. Risk diversification techniques, such as the 1/N investment rule, can help. Also, risk controls can add value by ensuring transparency in financial markets and transactions. Rating accuracy is also important for improved transparency. Performance contracts for top management help ensure self-interest is in line with overall performance.

Expansion risk is the risk that managers increase firm size because of self-interest, and regional financial regulations can limit this risk. Dynamic hedging and risk transfer are additional instruments for risk management, whereas political risk can be mitigated by using political connections. Finally, the authors assess background risk as an individual’s work effort, which can be adjusted through the labor–leisure trade-off.

This concise study examines several different risk management topics. In a relatively short space, the authors cover a wide range of topics and provide a useful starting point for investment professionals wanting to know more about risk management. They also discuss several examples of market risks and techniques for risk mitigation.