Markets for Financial Innovation

66 Pages Posted: 23 Jan 2019 Last revised: 11 Feb 2021

See all articles by Ana Babus

Ana Babus

Washington University in St. Louis - Department of Economics

Kinda Cheryl Hachem

University of Virginia - Darden School of Business

Multiple version iconThere are 2 versions of this paper

Date Written: January 2019

Abstract

Financial securities trade in a wide variety of market structures. This paper develops a theory in which both the market structure of trade and the payoffs of the claims being traded form endogenously. Financial intermediaries use the cash flows of an underlying asset to design securities for investors. The demand for securities arises as investors choose markets then trade using strategies represented by quantity-price schedules. We find that intermediaries create increasingly riskier securities when facing deeper markets in which investors trade more competitively. In turn, investors elicit safer securities when they choose to trade in thinner, more fragmented markets. These findings reveal a novel role for market fragmentation in the creation of safer securities. The model is also informative about which investor classes trade which securities and how the distributional properties of the underlying asset affect the relationship between security design and market structure.

Suggested Citation

Babus, Ana and Hachem, Kinda Cheryl, Markets for Financial Innovation (January 2019). NBER Working Paper No. w25477, Available at SSRN: https://ssrn.com/abstract=3319808

Ana Babus (Contact Author)

Washington University in St. Louis - Department of Economics ( email )

One Brookings Drive
St. Louis, MO 63130
United States

Kinda Cheryl Hachem

University of Virginia - Darden School of Business ( email )

P.O. Box 6550
Charlottesville, VA 22906-6550
United States

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