The Implications of Financial Innovation for Capital Markets and Household Welfare
43 Pages Posted: 9 Aug 2017 Last revised: 22 Aug 2018
Date Written: August 21, 2018
Our objective is to understand how financial innovation affects investors' optimal asset-allocation decisions and the economic mechanisms through which these decisions influence financial markets, welfare, and wealth inequality. We show that when some investors, such as households, are less confident than other investors about the dynamics of the new asset made available by financial innovation, but learn over time, many ''intuitive'' results are reversed: financial innovation increases the return volatility and risk premium of the new asset along with volatilities of investors' portfolios. Despite the increase in volatilities, financial innovation improves the welfare of all investors but worsens wealth inequality because experienced investors benefit more from it.
Keywords: household finance, household portfolio choice, wealth inequality, differences in beliefs, parameter uncertainty, Bayesian learning, recursive utility.
JEL Classification: G11, G12, D53
Suggested Citation: Suggested Citation