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Financial Innovation, Market Participation and Asset Prices

  • Laurent Calvet
  • Martin Gonzalez-Eiras
  • Paolo Sodini

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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File URL: http://www.economics.harvard.edu/pub/hier/2001/HIER1928.pdf
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Paper provided by Harvard - Institute of Economic Research in its series Harvard Institute of Economic Research Working Papers with number 1928.

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Date of creation: 2001
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Handle: RePEc:fth:harver:1928
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