Working Paper: CEPR ID: DP1454
Authors: James Dow
Abstract: I present a simple model in which it is possible that opening a new market makes everybody worse off. Unlike previous examples in the literature, the analysis does not rely on relative price changes of different consumption goods. This is shown in a standard framework in which uninformed traders with hedging needs interact with risk-averse informed traders in security markets where prices are set by a competitive market-making system. The paper emphasizes cross-market links between hedging and speculative demands: risk-averse arbitrageurs can hedge in the new market to lower the risk of speculative positions in the pre-existing market. This causes a greater incidence of speculative activity in the old market, leading some traders with pure hedging motives in that market to withdraw, so reducing liquidity in the old market. The general point argued here is that a risk-averse informed trader who believes an asset to be mispriced will typically be able to reduce the risk of speculating on his belief by hedging with other assets. The availability of such hedging instruments will in turn determine which types of speculative activity are of low risk, and this will influence the strategies to which traders will devote resources.
Keywords: arbitrage; hedging; financial innovation
JEL Codes: D60; D82; G12; G18
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Opening a new financial market (G10) | All agents are worse off (D69) |
| Increased arbitrage activity in the old market (G19) | Reduced liquidity (G19) |
| Withdrawal of traders with pure hedging motives (G19) | Reduced liquidity (G19) |
| Reduced liquidity (G19) | Wider bid-ask spread (G19) |
| Wider bid-ask spread (G19) | Harm to both arbitrageurs and hedgers (G19) |