Arbitrage, Hedging and Financial Innovation
I present a simple model in which it is possible that opening a new market makes everybody worse off. Unlike previous examples in the literature, the analysis does not rely on relative price changes of different consumption goods. This is shown in a standard framework in which uninformed traders with hedging needs interact with risk-averse informed traders in security markets where prices are set by a competitive market-making system. The paper emphasizes cross-market links between hedging and speculative demands: risk-averse arbitrageurs can hedge in the new market to lower the risk of speculative positions in the pre-existing market. This causes a greater incidence of speculative activity in the old market, leading some traders with pure hedging motives in that market to withdraw, so reducing liquidity in the old market. The general point argued here is that a risk-averse informed trader who believes an asset to be mispriced will typically be able to reduce the risk of speculating on his belief by hedging with other assets. The availability of such hedging instruments will in turn determine which types of speculative activity are of low risk, and this will influence the strategies to which traders will devote resources.
|Date of creation:||Aug 1996|
|Date of revision:|
|Contact details of provider:|| Postal: |
Phone: 44 - 20 - 7183 8801
Fax: 44 - 20 - 7183 8820
|Order Information:|| Email: |
When requesting a correction, please mention this item's handle: RePEc:cpr:ceprdp:1454. See general information about how to correct material in RePEc.
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.