Speculation and Risk Sharing with New Financial Assets
AbstractWhile the traditional view of financial innovation emphasizes the risk sharing role of new financial assets, belief disagreements about these assets naturally lead to speculation, which represents a powerful economic force in the opposite direction. This paper investigates the effect of financial innovation on portfolio risks in an economy when both the risk sharing and the speculation forces are present. I consider this question in a standard mean-variance framework. Financial assets provide hedging services but they are also subject to speculation because traders do not necessarily agree about their payoffs. I define the average variance of traders' net worths as a measure of portfolio risks for this economy, and I decompose it into two components: the uninsurable variance, defined as the average variance that would obtain if there were no belief disagreements, and the speculative variance, defined as the residual variance that results from speculative trades based on belief disagreements. Financial innovation always decreases the uninsurable variance because new assets increase the possibilities for risk sharing. My main result shows that financial innovation also always increases the speculative variance. This is true even if traders completely agree about the payoffs of new assets. The intuition behind this result is the hedge-more/bet-more effect: Traders use new assets to hedge their bets on existing assets, which in turn enables them to place larger bets and take on greater risks. The net effect of financial innovation on portfolio risks depends on the quantitative strength of its effects on the uninsurable and the speculative variances. I consider a calibration of the model for new assets linked to national incomes of G7 countries, which were recommended by Athanasoulis and Shiller (2001) to facilitate risk sharing. For reasonable levels of belief disagreements, these assets would actually increase the average consumption risks of individuals in G7 countries. In addition, a profit seeking market maker would introduce a different subset of these assets than the ones proposed by Athanasoulis and Shiller (2001). The endogenous set of new assets would be directed towards increasing the opportunities for speculation rather than risk sharing.
Download InfoIf you experience problems downloading a file, check if you have the proper application to view it first. In case of further problems read the IDEAS help page. Note that these files are not on the IDEAS site. Please be patient as the files may be large.
Bibliographic InfoPaper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 17506.
Date of creation: Oct 2011
Date of revision:
Note: AP CF IFM
Contact details of provider:
Postal: National Bureau of Economic Research, 1050 Massachusetts Avenue Cambridge, MA 02138, U.S.A.
Web page: http://www.nber.org
More information through EDIRC
Find related papers by JEL classification:
- D53 - Microeconomics - - General Equilibrium and Disequilibrium - - - Financial Markets
- D61 - Microeconomics - - Welfare Economics - - - Allocative Efficiency; Cost-Benefit Analysis
- G1 - Financial Economics - - General Financial Markets
- G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
This paper has been announced in the following NEP Reports:
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- Raghuram G. Rajan, 2005.
"Has Financial Development Made the World Riskier?,"
- Raghuram G. Rajan, 2005. "Has financial development made the world riskier?," Proceedings - Economic Policy Symposium - Jackson Hole, Federal Reserve Bank of Kansas City, issue Aug, pages 313-369.
- Brock, W.A. & Hommes, C.H. & Wagener, F.O.O., 2009.
"More hedging instruments may destabilize markets,"
Journal of Economic Dynamics and Control,
Elsevier, vol. 33(11), pages 1912-1928, November.
- Florian Wagener & Cars Hommes & William Brock, 2006. "More hedging instruments may destabilize markets," Working Papers wp06-11, Warwick Business School, Finance Group.
- Brock, W.A. & Hommes, C.H. & Wagener, F.O.O., 2006. "More hedging instruments may destabilize markets," CeNDEF Working Papers 06-12, Universiteit van Amsterdam, Center for Nonlinear Dynamics in Economics and Finance.
- William Brock & Cars Hommes & Florian Wagener, 2006. "More Hedging Instruments may destablize Markets," Tinbergen Institute Discussion Papers 06-080/1, Tinbergen Institute, revised 30 Apr 2008.
- Nicola Gennaioli & Andrei Shleifer & Robert Vishny, 2010.
"Financial Innovation and Financial Fragility,"
2010.114, Fondazione Eni Enrico Mattei.
- John Geanakoplos, 2009. "The Leverage Cycle," Cowles Foundation Discussion Papers 1715, Cowles Foundation for Research in Economics, Yale University.
- Duffie Darrell & Rahi Rohit, 1995. "Financial Market Innovation and Security Design: An Introduction," Journal of Economic Theory, Elsevier, vol. 65(1), pages 1-42, February.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: ().
If references are entirely missing, you can add them using this form.