Froot-Stein Risk Management Decoupling Model
Expert TheoryReview
When financial markets are incomplete, non-systematic background risk forces firms and agricultural producers to underinvest in high-return projects whose returns covary positively with existing risk exposures.
Picture this
Imagine a shopkeeper who refuses to stock expensive electronics because a flood could wipe out both their house and store at the same time; once insured against floods, they can stock high-end goods based purely on expected profit rather than fear of bankruptcy.
What the evidence says
Analytical proof establishing that optimal investment in risky projects is strictly decreasing in basis risk and insurance costs, but strictly increasing in exogenous insurance coverage.
- Who was studied
- CARA-normal theoretical microeconomic model of agricultural production decisions under index insurance.
- How
- Comparative statics derivation of optimal investment under background risk and imperfect index hedging.
What to do
Deploy state-contingent hedging instruments to decouple investment decisions from background volatility in credit- and risk-constrained enterprises.
From the source
"Improving access to insurance against production risk allows the farmer to reduce the background risk associated with any given investment level (i.e. to shift this risk-return frontier outwards), allowing the farmer to invest more in equilibrium."
How Does Risk Management Influence Production Decisions? Evidence from a Field Experiment