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Profitable Innovation Without Patent Protection: The Case of Derivatives

  • Helios Herrera

    (ITAM)

  • Enrique Schroth

    (HEC Lausanne and FAME)

Investment banks find it profitable to invest in the development of innovative derivative securities even without being able to preclude early competition from other investment banks using patents. To explain this, we assume that the developer can learn from the first issues of the innovative financial product and is able to become the expert issuer by the time imitation enters the market. We show how this becomes an informational first-mover advantage that turns innovators into the market leader. It is this advantage, and not the typical temporary monopoly position awarded to a patent holder, that provides the incentive to pay the development costs. In the aftermath, the innovator ends up with the largest share of the underwriting market and makes positive profits. Our model’s predictions are consistent with many stylized facts of financial innovations by investment banks.

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Paper provided by International Center for Financial Asset Management and Engineering in its series FAME Research Paper Series with number rp76.

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Date of creation: Jan 2003
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Handle: RePEc:fam:rpseri:rp76
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  1. Boldrin, Michele & Levine, David, 2002. "Perfectly Competitive Innovation," CEPR Discussion Papers 3274, C.E.P.R. Discussion Papers.
  2. Benoit, Jean-Pierre, 1985. "Innovation and Imitation in a Duopoly," Review of Economic Studies, Wiley Blackwell, vol. 52(1), pages 99-106, January.
  3. Tufano, Peter, 1989. "Financial innovation and first-mover advantages," Journal of Financial Economics, Elsevier, vol. 25(2), pages 213-240, December.
  4. Enrique Schroth, 2002. "Innovation and First-Mover Advantages in Corporate Underwriting: Evidence from Equity Linked Securities," FAME Research Paper Series rp74, International Center for Financial Asset Management and Engineering.
  5. Reinganum, Jennifer R., 1982. "Uncertain Innovation and the Persistence of Monopoly," Working Papers 431, California Institute of Technology, Division of the Humanities and Social Sciences.
  6. Steven A. Sharpe, 1989. "Asymmetric information, bank lending, and implicit contracts: a stylized model of customer relationships," Finance and Economics Discussion Series 70, Board of Governors of the Federal Reserve System (U.S.).
  7. Bhattacharyya, Sugato & Nanda, Vikram, 2000. "Client Discretion, Switching Costs, and Financial Innovation," Review of Financial Studies, Society for Financial Studies, vol. 13(4), pages 1101-27.
  8. Josh Lerner, 2004. "Where Does State Street Lead? First Look at Finance Patents, 1971-2000," Levine's Working Paper Archive 122247000000000497, David K. Levine.
  9. Miller, Merton H., 1986. "Financial Innovation: The Last Twenty Years and the Next," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 21(04), pages 459-471, December.
  10. Diamond, Douglas W, 1991. "Debt Maturity Structure and Liquidity Risk," The Quarterly Journal of Economics, MIT Press, vol. 106(3), pages 709-37, August.
  11. Fama, Eugene F., 1985. "What's different about banks?," Journal of Monetary Economics, Elsevier, vol. 15(1), pages 29-39, January.
  12. Peter Tufano, 1995. "Securities Innovations: A Historical And Functional Perspective," Journal of Applied Corporate Finance, Morgan Stanley, vol. 7(4), pages 90-104.
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