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Financial Innovation, Market Participation and Asset Prices

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  • Calvet, Laurent

    (Harvard University, Department of Economics)

  • Gonzalez-Eiras, Martin

    (Universidad de San Andres, Departamento de Economia)

  • Sodini, Paolo

    (Dept. of Finance, Stockholm School of Economics)

Abstract

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.

Suggested Citation

  • Calvet, Laurent & Gonzalez-Eiras, Martin & Sodini, Paolo, 2001. "Financial Innovation, Market Participation and Asset Prices," SSE/EFI Working Paper Series in Economics and Finance 464, Stockholm School of Economics.
    • Handle: RePEc:hhs:hastef:0464
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    More about this item

    Keywords

    Endogenous Participation; Epstein-Zin Utility; Financial Innovation; Incomplete Markets; Multiple Risk Factors; Risk Premium; Spanning.;
    All these keywords.

    JEL classification:

    • D52 - Microeconomics - - General Equilibrium and Disequilibrium - - - Incomplete Markets
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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