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The Choice Channel of Financial Innovation

Listed author(s):
  • Felipe S. Iachan
  • Plamen T. Nenov
  • Alp Simsek

Financial innovations in recent decades have vastly expanded investors' portfolio choice. We theoretically analyze the effect of these developments on investors' savings and asset returns. In our model, investors with possibly heterogeneous beliefs choose their savings portfolios. Under mild assumptions, we establish a choice channel by which greater portfolio choice increases investors' (perceived) return from saving, and induces them to save more. We then investigate the asset pricing implications of the choice channel, which depend on the type of financial innovation. Our main result shows that greater customization, which we capture with improved ability to trade risky assets other than the market portfolio, reduces the expected return on every asset. This result is consistent with the decline in the risk-free interest rate since the early 1980s, and is in contrast with the "precautionary savings" literature that would make the opposite prediction. Greater participation, which we capture with improved ability to trade the market portfolio, reduces the risk premia but typically increases the risk-free rate. We also analyze the effect of greater securitization, which we capture with a relaxation of constraints to issue risk-free promises in an environment in which there is a high demand for safe assets.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 21686.

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Date of creation: Oct 2015
Handle: RePEc:nbr:nberwo:21686
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