SSE/EFI Working Paper Series in Economics and Finance
No 464:
Financial Innovation, Market Participation and Asset Prices
Laurent Calvet, Martin Gonzalez-Eiras ()
and Paolo Sodini ()
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.
Keywords: Endogenous Participation; Epstein-Zin Utility; Financial Innovation; Incomplete Markets; Multiple Risk Factors; Risk Premium; Spanning.; (follow links to similar papers)
JEL-Codes: D52; E44; G12; (follow links to similar papers)
46 pages, August 1, 2001
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