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Financial Innovation, Market Participation, and Asset Prices

  • Martin Gonzalez Eiras

    ()

    (Department of Economics, Universidad de San Andres)

  • Laurent Calvet

    (Harvard University)

  • Paolo Sodini

    (Stockholm School of Economics)

This paper investigates the pricing effects of financial innovation in an economy with endogenous participation and heterogeneous income risks. The introduction of non-redundant assets endogenously modifies the participation set, reduces the covariance between dividends and participants' consumption and thus leads to lower risk premia. In multisector economies, financial innovation spreads across markets through the diversified portfolio of new entrants, and has rich effects on the cross-section of expected returns. The price changes can also lead some investors to leave the markets and give rise to non-degenerate forms of participation turnover. The model is consistent with several features of financial markets over the past few decades: substantial innovation, higher participation, significant turnover in investor composition, improved risk management practices, a slight increase in real interest rates, and a reduction in risk premia.

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Paper provided by Universidad de San Andres, Departamento de Economia in its series Working Papers with number 76.

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Date of creation: Sep 2004
Date of revision: Sep 2004
Publication status: Published in Journal of Financial and Quantitative Analysis, Vol. 39, No. 3, September 2004
Handle: RePEc:sad:wpaper:76
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