Financial Complexity and Trade

25 Pages Posted: 12 Jun 2018 Last revised: 10 Sep 2018

Date Written: November 02, 2018

Abstract

What are the implications on trading activity if investors are not sophisticated enough to understand and evaluate trades that have a complex payoff structure? Can frictions generated by this type of financial complexity be so severe that they lead to a complete market freeze, like that of the recent financial crisis? Starting from an allocation that is not Pareto optimal, we find that whether complexity impedes trade depends on how investors perceive risk and uncertainty. For smooth convex preferences, such as subjective expected utility, complexity cannot halt trade, even in the extreme case where each investor is so unsophisticated that he can only trade up to one Arrow-Debreu security, without being able to combine two or more in order to construct a complex trade. However, for non-smooth preferences, which allow for kinked indifference curves, such as maxmin expected utility, complexity can completely shut down trade.

Keywords: Financial Complexity, Financial Crises, Agreeable Bets, Agreeable Trades, No Trade, Betting, Ambiguity Aversion

JEL Classification: D70, G01

Suggested Citation

Galanis, Spyros, Financial Complexity and Trade (November 02, 2018). Games and Economic Behavior, Available at SSRN: https://ssrn.com/abstract=3185076 or http://dx.doi.org/10.2139/ssrn.3185076

Spyros Galanis (Contact Author)

Durham University ( email )

Durham, DH1 3LE
Great Britain

Do you have a job opening that you would like to promote on SSRN?

Paper statistics

Downloads
73
Abstract Views
704
Rank
657,259
PlumX Metrics