Thursday, August 1, 2013

Financial Innovation and Speculation

Financial innovation is generally presumed to facilitate diversification and risk sharing. A new paper by Alp Simsek, "Speculation and Risk Sharing with New Financial Assets," suggests that increased speculation may be an additional effect of financial innovation.

The key insight underlying Simsek's theoretical model, and a fact ignored by the traditional literature on financial innovation and portfolio risk, is that market participants are likely to disagree about how to value financial assets. His thesis is that "belief disagreements change the implications of financial innovation for portfolio risks." An existing large literature analyzes the implications of belief disagreements for trading volume and asset prices, but the novelty of Simsek's paper is to analyze the implications of belief disagreements on portfolio riskiness.

In the model, traders take positions in a set of financial assets, allowing them to share and diversify some of their income risks. Suppose traders have heterogeneous beliefs about the payoffs of some asset. The introduction of a new asset leads to riskier portfolios through two channels. First is a direct channel. An investor who is more optimistic than average about the asset’s payoff may take a positive net position in the asset even if her background risk covaries positively with the asset payoff. This is a speculative bet, since it increases the riskiness of her portfolio. Second is a less direct channel called the hedge-more/bet-more effect, through which a new asset amplifies risky bets about existing assets. To illustrate this effect, Simsek gives an example of two currency traders taking positions in the Swiss franc (existing asset) and the euro (new asset):
"Traders have different views about the franc but not the euro, perhaps because they disagree about the prospects of the Swiss economy but not the euro zone. First, suppose traders can only take positions on the franc. In this case, traders do not take too large speculative positions because the franc is affected by several sources of risks, some of which they don’t disagree about. Traders must bear all of these risks, which makes them reluctant to speculate. Next suppose the euro is also introduced for trade. In this case, traders complement their positions in the franc by taking opposite positions in the euro. By doing so, traders hedge the risks that also affect the euro, which enables them to take purer bets on the franc. When traders are able to take purer bets, they also take larger and riskier bets. Consequently, the introduction of the euro in this example increases portfolio risks even though traders do not disagree about its payoff."
A very interesting portion of the paper concerns the endogenous introduction of new assets. New assets do not just exogenously appear in practice. Rather, they are introduced by agents with profit incentives. The literature on endogenous financial innovation tends to emphasize the risk-sharing motive as a driving force. But is the risk-sharing motive for financial innovation still dominant even with belief disagreement? Simsek writes:
"I address this question by introducing a profit-seeking market maker that innovates new assets for which it subsequently serves as the intermediary. The market maker’s expected profits are proportional to traders’ willingness to pay to trade the new assets. Thus, traders’ speculative trading motive and their risk-sharing motive create innovation incentives... When belief disagreements are sufficiently large, the endogenous assets maximize the average variance among all possible choices. Intuitively, the market maker innovates speculative assets that enable traders to bet most precisely on their disagreements, completely disregarding the risk-sharing motive."
Simsek explicitly avoids drawing any policy implications from his results, "because financial innovation might also affect welfare through various other channels not captured in this model." Simsek's paper is motivated by the proliferation of new financial assets in recent years, such as new types of futures, swaps, options, and exotic derivatives. I presume that he has in mind the possibility that the introduction of these assets played a role in the financial crisis, through the theoretical mechanisms detailed in his paper. There are many other historical episodes in which the introduction of a new type of asset was followed by a speculative episode. In the seventeenth century, for example, tulip bulbs took on the role of an asset; intense speculation and an eventual market crash followed. Shares of the South Sea Company were also a new sort of asset upon their introduction in the 18th century, and also prompted speculation.


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  2. Another excellent post on financial innovation. If you'd like to read more about how companies are innovating the financial services sector, check out how Modern Analytics is revolutionizing analytics in financial services with their cutting-edge solution called Model Factory.


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