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Financial Innovation, Market Participation, and Asset Prices

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  • Calvet, Laurent
  • Gonzalez-Eiras, Martín
  • Sodini, Paolo

Abstract

This paper proposes that the introduction of non-redundant assets can endogenously modify trader participation in financial markets, which can lead to a lower market premium and a higher interest rate. We demonstrate this mechanism in a tractable exchange economy with endogenous participation. Investors receive heterogeneous random incomes determined by a finite number of macroeconomic factors. They can freely borrow and lend, but must pay a fixed entry cost to invest in risky assets. Security prices and the participation structure are jointly determined in equilibrium. The model reconciles a number of features that have characterized financial markets in the past three decades: substantial financial innovation; a sharp increase in investor participation; improved risk management practices; an increase in interest rates; and a reduction in the risk premium.

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Bibliographic Info

Article provided by Cambridge University Press in its journal Journal of Financial and Quantitative Analysis.

Volume (Year): 39 (2004)
Issue (Month): 03 (September)
Pages: 431-459

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Handle: RePEc:cup:jfinqa:v:39:y:2004:i:03:p:431-459_00

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