Working Paper: NBER ID: w9840
Authors: Laurent Calvet; MartÃn Gonzalezeiras; Paolo Sodini
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 interest rates; and a reduction in risk premia.
Keywords: Financial Innovation; Market Participation; Asset Prices
JEL Codes: D52; E44; G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| introduction of nonredundant assets (G19) | greater participation in financial markets (G19) |
| greater participation in financial markets (G19) | lower market premium (D49) |
| financial innovation (O16) | changes in risk premia across different sectors (G19) |
| price changes from financial innovation (G19) | participation turnover (J63) |
| introduction of nonredundant assets (G19) | lower covariance between stock returns and participants' consumption (E21) |