Working Paper: NBER ID: w25450
Authors: Barney Hartman-Glaser; Benjamin M. Hbert
Abstract: We model the widespread failure of contracts to share risk using available indices. A borrower and lender can share risk by conditioning repayments on an index. The lender has private information about the ability of this index to measure the true state that the borrower would like to hedge. The lender is risk averse and thus requires a premium to insure the borrower. The borrower, however, might be paying something for nothing if the index is a poor measure of the true state. We provide sufficient conditions for this effect to cause the borrower to choose a non-indexed contract instead.
Keywords: Risk Sharing; Financial Contracts; Asymmetric Information; Mortgage Market
JEL Codes: D82; D86; G21
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Risk-averse lenders and more risk-averse borrowers (G21) | Non-contingent contracts equilibrium (D86) |
| Non-contingent contracts equilibrium (D86) | Borrowers reject indexed contracts (G51) |
| Lenders knowing true quality of the index (G21) | Contracts that may benefit lenders but perceived unfavorable by borrowers (G21) |
| Adverse selection problem faced by borrowers (D82) | Rejection of indexed contracts (D86) |
| Failure of agents to share risk (D82) | Similar to 'lemons market' phenomenon (L15) |
| Conditions for non-contingent equilibrium (C62) | Importance of risk aversion (D81) |
| Non-contingent equilibrium can persist even when Pareto dominated by full-information optimal contracts (D52) | Significant inefficiency in market for contracts (D86) |