A Normative Analysis of New Financially Engineered Derivatives

Abstract:     
This Article analyzes whether the introduction of new derivative assets makes a society better or worse off. Because trading such non-redundant derivatives produces new distributions of income across time and over possible future contingencies, individuals can utilize such financial instruments to hedge risks not possible before the introduction of these assets. Thus, it may seem that new derivatives unambiguously benefit society. In fact, introducing sufficiently many new derivatives completes asset markets. Asset markets are complete if trading on them can attain every possible payoff pattern of wealth across time and over possible future contingencies. The first fundamental theorem of welfare economics provides that if asset markets are complete and perfectly competitive, the resulting equilibrium allocation of assets, commodities, and risk is Pareto-efficient. Thus, new derivatives that complete asset markets are unambiguously socially desirable.

But, from the perspective of most households, the empirical reality is that asset markets are severely incomplete. Trading on incomplete asset markets cannot achieve some distributions of money across time and over possible future contingencies. The recognition that asset markets are incomplete has three far-reaching implications for regulatory policy towards new derivatives. First, for most societies, the addition of new derivatives to sufficiently incomplete asset markets can make all households worse off. Second, for most societies, a regulator can make all households better off by reallocating existing asset portfolios without introducing any new assets. Third, although government regulation can in principle improve the social allocation of risk and the resulting levels of households' utilities, it may not due to informational, decisional or political limitations on real world regulators. These important normative implications of an incomplete asset markets analysis inform the debate over how to regulate new derivatives.

JEL Classifications: G18, G24, K22

Accepted Paper Series