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Financial Innovation, Market Participation and Asset Prices

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  • Calvet, Laurent

    (Harvard University, Department of Economics)

  • Gonzalez-Eiras, Martin

    ()
    (Universidad de San Andres, Departamento de Economia)

  • Sodini, Paolo

    ()
    (Dept. of Finance, Stockholm School of Economics)

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

Paper provided by Stockholm School of Economics in its series Working Paper Series in Economics and Finance with number 464.

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Length: 46 pages
Date of creation: 01 Aug 2001
Date of revision:
Handle: RePEc:hhs:hastef:0464

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Keywords: Endogenous Participation; Epstein-Zin Utility; Financial Innovation; Incomplete Markets; Multiple Risk Factors; Risk Premium; Spanning.;

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