State Contingent Assets, Financial Crises and Pecuniary Externalities in Models with Collateral Constraints

This paper analyzes the effect of developing financial markets for contingent assets on the degree of risk sharing and its ability to reduce spillover effects due to credit externalities. In an environment with persistent shocks and collateral constraints, state contingent assets allow for partial hedging against income fluctuations, which reduce the need for precautionary savings and lower the incidence of financial crises. In addition, these assets reduce the size of spillover effects of individual leverage on the valuation of the collateral constraint of other agents, but is not able to fully correct the pecuniary externality. Private agents take too little state contingent debt by ignoring the larger hedging properties of this instrument against the debt deflation mechanism.