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Financial Innovation, Market Participation, and Asset Prices

Published online by Cambridge University Press:  06 April 2009

Laurent Calvet ,
Martín Gonzalez-Eiras  and
Paolo Sodini
Laurent Calvet
Affiliation:
lcalvet@aya.yale.edu, Department of Economics, Harvard University, Cambridge, MA 02138, Department of Finance, Stern School of Business, New York, NY 10012, and NBER;
Martín Gonzalez-Eiras
Affiliation:
mge@udesa.edu.ar, Departamento de Economía, Universidad de San Andrés, Vito Dumas 284 (1644), Victoria, Buenos Aires, Argentina;
Paolo Sodini
Affiliation:
paolo.sodini@hhs.se, Department of Finance, Stockholm School of Economics, Sveavägen 65, Box 6501, SE-113 83 Stockholm, Sweden.
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Abstract

This paper investigates the pricing effects of financial innovation in an economy with endogenous participation and heterogeneous income risks. The introduction of non-redundant assets endogenously modifies the participation set, reduces the covariance between dividends and participants' consumption and thus leads to lower risk premia. In multisector economies, financial innovation spreads across markets through the diversified portfolio of new entrants, and has rich effects on the cross-section of expected returns. The price changes can also lead some investors to leave the markets and give rise to non-degenerate forms of participation turnover. The model is consistent with several features of financial markets over the past few decades: substantial innovation, higher participation, significant turnover in investor composition, improved risk management practices, a slight increase in real interest rates, and a reduction in risk premia.

Type
Research Article
Information
Journal of Financial and Quantitative Analysis , Volume 39 , Issue 3 , September 2004 , pp. 431 - 459
Copyright
Copyright © School of Business Administration, University of Washington 2004

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