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There has been a lot of discussion for a while now over how the short market on Tesla is quite crowded. This got me thinking of what possible benefits the short market bestows upon the economy as a whole.

Specifically, supposing some hypothetical company $C$ (that isn't Tesla), that has random payoff at time $t$ of $P_t(x)$ where $x$ is the investment. Supposing that $P_t$ is 'risky' (e.g. $p(P_t(x) = x) = 1$ is 'non risky', and $p(P_t(x) = 2.5x) = 0.5; p(P_t(x) = 0) = 0.5$ is 'risky').

I can vaguely imagine that a mixture of investors and shorters would somehow even out the expected risk for the economy as a whole. Does this intuition hold in reality? If so, what is the mechanism and reasoning here?

I can see at least one avenue by which aggregate risk to the economy can be insured under the right circumstances. Suppose that we have the "risky" business $C$ as defined above. Ceate another business $C_2$ with the same payout, but which succeeds or fails exactly when $C$ fails or succeeds, respectively. If we invest $x/2$ into each company, the payout at time $t$ is exactly $1.25x$ with probability 1. Thus, $C_2$ "evens out" the risk of $C$, and vice versa.

Do short positions also fill this role? Does anything else?

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  • $\begingroup$ What does "even out the expected risk for the economy as a whole" mean? $\endgroup$ – Giskard Sep 27 '18 at 21:14
  • $\begingroup$ Suppose that EVERYONE invests in a risky company $C$, and company $C$ fails. Then there is a net detriment to the economy as a whole. Even if only half of everyone does, there is a detriment. However, if the other half of everyone shorts $C$, then is the overall impact to the economy mitigated somehow when $C$ fails? $\endgroup$ – Scott Sep 27 '18 at 22:08
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    $\begingroup$ The question is vague. The aggregate risk to the whole economy cannot be insured by definition. The idiosyncratic risk, e.g. for the company C, can be insured, and shorting is one way of hedging. For example, an employee of C who will be out of a job when C fails and is risk-averse would benefit from shorting C (if legally allowed), because the short would make money if C fails. This is just the event that the employee needs money in, because they lose their job. $\endgroup$ – Sander Heinsalu Sep 28 '18 at 1:06
  • $\begingroup$ That is a beautiful generalization of the problem my question is getting at. "Can risk to the whole economy be insured?" You might be able to if, for example, there were another company $B$ that profited or lost just when $C$ lost or profited respectively. Regardless of which company "won" the average would be positive. Does shorting fill a similar role? $\endgroup$ – Scott Sep 28 '18 at 1:59

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