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New financial markets: who gains and who loses

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  • Paul Willen
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    Abstract

    We evaluate the effects of new financial markets in a two-period incomplete markets model with heterogenous agents. For analytical tractability, we focus on the special case where utility is exponential and risks are normally distributed. We provide a complete characterization of life-cycle consumption and portfolio choice. The effect of new financial markets on individual welfare equals the sum of what we call the portfolio effect and the price effect. The portfolio effect is proportional to the square of the difference between the average exposure to the new asset in the economy and an individual investor’s exposure adjusted for risk aversion. The portfolio effect is always positive and measures the improved ability of investors to transfer consumption across states. The price effect captures the effect on individual welfare of changes in asset prices. We show that new financial markets drive down the prices of all assets which raises the interest rate and thus affects the ability of investors to transfer consumption across time. The price effect is positive for net savers but can be negative for net borrowers. For net borrower households, the price effect can wipe out the portfolio effect and lead to welfare reductions. Copyright Springer-Verlag Berlin/Heidelberg 2005

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    File URL: http://hdl.handle.net/10.1007/s00199-004-0511-7
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    Bibliographic Info

    Article provided by Springer in its journal Economic Theory.

    Volume (Year): 26 (2005)
    Issue (Month): 1 (07)
    Pages: 141-166

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    Handle: RePEc:spr:joecth:v:26:y:2005:i:1:p:141-166

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    Related research

    Keywords: Incomplete markets; Financial innovation; Risk-sharing.;

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    Cited by:
    1. Rohit Rahi & Jean-Pierre Zigrand, 2007. "Strategic financial innovation in segmented markets," LSE Research Online Documents on Economics 24503, London School of Economics and Political Science, LSE Library.
    2. Willems, Bert & Morbee, Joris, 2010. "Market completeness: How options affect hedging and investments in the electricity sector," Energy Economics, Elsevier, vol. 32(4), pages 786-795, July.
    3. Juan Angel Garcia & Adrian van Rixtel, 2007. "Inflation-linked bonds from a Central Bank perspective," Occasional Paper Series 62, European Central Bank.
    4. Mercereau, Benoit, 2006. "Stock markets and the real exchange rate: An intertemporal approach," Journal of International Money and Finance, Elsevier, vol. 25(7), pages 1130-1145, November.

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