Scandinavian Working Papers in Economics

SSE/EFI Working Paper Series in Economics and Finance,
Stockholm School of Economics

No 464: Financial Innovation, Market Participation and Asset Prices

Laurent Calvet , Martin Gonzalez-Eiras () and Paolo Sodini ()
Additional contact information
Laurent Calvet: Harvard University, Department of Economics, Postal: Littauer Center, Cambridge, MA 02138, USA
Martin Gonzalez-Eiras: Universidad de San Andres, Departamento de Economia, Postal: Vito Dumas 284 (1644), Victoria, Buenos Aires, Argentina
Paolo Sodini: Dept. of Finance, Stockholm School of Economics, Postal: P.O. Box 6501, S-113 83 Stockholm, Sweden

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.

JEL-codes: D52; E44; G12

46 pages, August 1, 2001

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