Monopolistic Security Design in Finance Economies

The purpose of this paper is to analyze endogenous asset innovation by an entrepreneurial exchange owner in a partial equilibrium model of incomplete security markets with financial transaction fees. A monopolistic market maker has the technology to introduce new securities into the economy and charge investors transaction fees if they trade on the exchange. The market maker's objective is to choose the security and transaction fee that maximize profits when opening the exchange. We compute the effects of asset innovation for the case of an option exchange introducing an option on a stock index. In the first set of economies agents with heterogeneous levels of risk aversion trade securities to achieve some risk sharing. In the second set of economies agents have identical risk aversion but heterogeneous beliefs which lead to trading due to the desire for portfolio re-balancing. In both types of models the introduction of the profit-maximizing options leads to a decrease of the prices of established securities. Typically small heterogeneity of beliefs lead to substantial more trading volume in the option than reasonable differences among levels of risk aversion. Our computational approach allows us to examine some previous results in the theoretical literature for heterogeneous-beliefs models about the effects of an option introduction. We show that these results about options leading to a price increase of the underlying stock depend on some very strong assumptions on the parameters and are quantitatively negligible. Typically an opposite result, namely a price decrease of the underlying stock, of much larger quantitative magnitude holds.