Catastrophe Futures: Financial Markets and Changing Climate Risks

Abstract

An economy faces an unknown individual risk, such as the health effects of a recently discovered environmental hazard. Opinions may be widely different about the distribution of risks across the population. We study financial markets that suffice to reach efficient allocations in this situation. The problem is formalized in a general equilibrium economy with incomplete markets. Introducing an array of mutual insurance policies and of "statistical securities" is shown to lead to Pareto efficient allocations. By combining insurance contract for individual risks and securities markets for collective risks, the proposed institutional framework economizes significantly on the number of markets required for efficiency. The computational complexity of a market equilibrium is reduced from an NP - complete (i.e. intractable) problem to one which depends polynomially on the number of households.

JEL Classification: G22, G13