Equilibrium in risk-sharing games

Abstract: The large majority of risk-sharing transactions involve few agents, each of whom can heavily influence the structure and the prices of securities. This paper proposes a game where agents' strategic sets consist of all possible sharing securities and pricing kernels that are consistent with Arrow-Debreu sharing rules. First, it is shown that agents' best response problems have unique solutions. The risk-sharing Nash equilibrium admits a finite-dimensional characterisation and it is proved to exist for arbitrary number of agents and be unique in the two-agent game. In equilibrium, agents declare beliefs on future random outcomes different than their actual probability assessments, and the risk-sharing securities are endogenously bounded, implying (among other things) loss of efficiency. In addition, an analysis regarding extremely risk tolerant agents indicates that they profit more from the Nash risk-sharing equilibrium as compared to the Arrow-Debreu one.

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The authors model how economic agents choose the beliefs on future uncertain events that they are going to declare to their counterparties and study whether such strategic behaviour yields an equilibrium in a two-period financial economy. Presented results demonstrate how the game leads to risk-sharing inefficiency and security mispricing, both of which are quantitatively characterised in analytic form. It is shown that equilibrium securities have endogenous limited liability, a typically suboptimal feature that is observed in practice. Even though agents' set of strategic choices is infinite-dimensional, the authors, among other things, establish that a Nash equilibrium admits a finite-dimensional characterisation; in fact, the dimension is one less than the number of participating agents. This characterisation in particular provides a concrete algorithm to compute the equilibrium transaction, as well as to prove the existence of a Nash equilibrium for an arbitrary (finite) number of players. In an important case of two players, Nash equilibrium is shown to be unique. Except for the assumed CARA preferences, no extra assumptions on the probability space or random payoffs are made. Further, the authors also show that agents with sufficiently low risk-aversion will prefer the risk-sharing game to the outcome of an Arrow-Debreu equilibrium that would have resulted from the absence of strategic behaviour, leading to an aggregate loss of risk-sharing welfare; this result is valid irrespective of the actual risky positions and subjective beliefs of the agents.

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