Hedging Financial Risks Subject to Asymmetric Information

This article presents a generalized approach to pricing risk in markets that are subject to information asymmetries. Asymmetric information can result in prohibitive trading costs and prevent the otherwise mutually beneficial exchange of risk. When dealing with risks typically transferred outside the capital markets, the problem of asymmetric information is even more pronounced than with financial risks, even risks priced in less liquid financial markets. A product that immunizes a client against a certain business or insurance event represents a challenge for pricing, as the client has superior information about the risks faced. The authors propose that in an incomplete market, the efficient solution is a dual‐triggered, contingent contract based on “indifference pricing” (i.e. reservation price) of residual variance.