Speculative Financial Innovation

35 Pages Posted: 21 Feb 2014

See all articles by Huining Henry Cao

Huining Henry Cao

Cheung Kong Graduate School of Business

Hui Ou-Yang

Cheung Kong Graduate School of Business

Dongyan Ye

Cheung Kong Graduate School of Business

Date Written: January 30, 2014

Abstract

We analyze how speculative financial innovation affects stock prices, option prices, risk premium, market liquidity, and investor welfare in an economy with heterogeneous beliefs. When investors disagree about the covariance of the newly introduced stocks with the original stocks, we show that financial innovation reduces the variance covariance matrix of the representative investor, which in turn decreases the risk premium of the market portfolio. When investors disagree on the expected payoff of the new stocks, the representative investor's expected payoff of the existing stocks will also change due to hedging demands among investors, which causes the stock prices to change. The reduction in the representative investor's variance covariance matrix of the existing stocks also results in the implied volatility in options prices to drop. The net effect on option prices is ambiguous as financial innovation also affects the prices of the original stocks. Financial innovation further causes the market liquidity to increase as prices will be less sensitive to supply shocks due to reduced variance covariance matrix of the representative investor. Finally, we show that financial innovation could make all investors better off under their own beliefs but worse off under the true beliefs.

Suggested Citation

Cao, Huining Henry and Ou-Yang, Hui and Ye, Dongyan, Speculative Financial Innovation (January 30, 2014). Available at SSRN: https://ssrn.com/abstract=2398726 or http://dx.doi.org/10.2139/ssrn.2398726

Huining Henry Cao (Contact Author)

Cheung Kong Graduate School of Business ( email )

Oriental Plaza, Tower E3
One East Chang An Avenue
Beijing, 100738
China

Hui Ou-Yang

Cheung Kong Graduate School of Business ( email )

Hong Kong
China
852-5199-6227 (Phone)

Dongyan Ye

Cheung Kong Graduate School of Business ( email )

Oriental Plaza, Tower E3
One East Chang An Avenue
Beijing, 100738
China

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