Financial Innovation, Market Participation and Asset Prices
47 Pages Posted: 4 Oct 2001
Date Written: August 2001
This paper proposes that the introduction of non-redundant assets can endogenously modify trader participation in financial markets, which can lead to a lower market premium and a higher interest rate. We demonstrate this mechanism in a tractable exchange economy with endogenous participation. Investors receive heterogeneous random incomes determined by a finite number of macroeconomic factors. They can freely borrow and lend, but must pay a fixed entry cost to invest in risky assets. Security prices and the participation structure are jointly determined in equilibrium. The model reconciles a number of features that have characterized financial markets in the past three decades: substantial financial innovation; a sharp increase in investor participation; improved risk management practices; an increase in interest rates; and a reduction in the risk premium.
Keywords: Endogenous Participation, Epstein-Zin Utility, Financial Innovation, Incomplete Markets, Multiple Risk Factors, Risk Premium, Spanning
JEL Classification: D52, E44, F36, G12
Suggested Citation: Suggested Citation