Speculative Financial Innovation
35 Pages Posted: 21 Feb 2014
Date Written: January 30, 2014
We analyze how speculative financial innovation affects stock prices, option prices, risk premium, market liquidity, and investor welfare in an economy with heterogeneous beliefs. When investors disagree about the covariance of the newly introduced stocks with the original stocks, we show that financial innovation reduces the variance covariance matrix of the representative investor, which in turn decreases the risk premium of the market portfolio. When investors disagree on the expected payoff of the new stocks, the representative investor's expected payoff of the existing stocks will also change due to hedging demands among investors, which causes the stock prices to change. The reduction in the representative investor's variance covariance matrix of the existing stocks also results in the implied volatility in options prices to drop. The net effect on option prices is ambiguous as financial innovation also affects the prices of the original stocks. Financial innovation further causes the market liquidity to increase as prices will be less sensitive to supply shocks due to reduced variance covariance matrix of the representative investor. Finally, we show that financial innovation could make all investors better off under their own beliefs but worse off under the true beliefs.
Suggested Citation: Suggested Citation