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Implications of Financial Innovation for Capital Markets and Household Welfare
Research / 22 January, 2019
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Professor of Finance
Grigory Vilkov is the Professor in the Department of Finance at Frankfurt School of Finance & Management. Grigory's preferred topic so far has been the use of derivative instruments and option-implied information in asset pricing and portfolio management, and general equilibrium modeling with frictions.

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Financial markets are being transformed by the rapid pace of financial innovation, which makes available new asset classes (The new asset classes into which households can invest include hedge funds, private equity, emerging-market equity and debt, mezzanine and distressed debt, real estate, infrastructure, commodities, and cryptocurrencies) and financial products with increasingly complex payoff structures (for an example of a structured product designed to increase household participation in the stock market by offering downside protection, see Calvet, Celerier, Sodini, and Vallee (2017). Other new strategies being offered include equity-linked certificates of deposit, smart-beta investments, and alternative-alpha products) to households that previously did not have access to them. For instance, Foxman (2018) writing in Bloomberg reports that “JPMorgan Chase & Co. plans to offer sophisticated investments to a much broader clientele. The bank is slashing requirements to participate in certain alternative investments that its asset management arm once offered mainly to institutions or the ultra rich.” At the same time, motivated partly by the low yields on traditional asset classes, a dazzling array of new financial products is being supplied to households; for example, Celerier and Vallee (2017) document that, “Since the end of the 1990s, European financial institutions have designed, marketed and sold more than 2 trillion euros of complex financial products to households.” Moreover, the transition from defined-benefit to defined-contribution pension plans, which requires households to make their own financial decisions, makes it increasingly important to understand the effects of financial innovation.

Effects of Financial Innovation: Traditional View

Accordingly, the objective of our research is to study the optimal asset-allocation decisions of investors that get access to a new asset and the economic mechanisms through which these decisions influence financial markets, welfare, and wealth inequality. In particular, the questions we address in our research include the following: Should we expect inexperienced investors, such as households, who are not fully confident about the new asset, to include it in their portfolios at all? How should we expect inexperienced investors to revise their portfolios over time as they learn about the new asset? What will be the impact of investors’ trading decisions on the return volatilities and risk premia of new and traditional assets—upon the introduction of the new asset, and in the long run? What will be the welfare consequences of financial innovation and how will it affect wealth inequality between inexperienced and experienced investors?

The traditional literature on financial innovation assumes that all investors in the economy are fully confident about the return process for the new asset. Under this assumption, it predicts that financial innovation facilitates risk sharing across investors while also improving diversification of each investor’s portfolio. Thus, financial innovation should smooth consumption, leading to a decrease in the return volatility and risk premium of the new asset. Moreover, financial innovation should improve welfare, with the wealth distribution across investors being constant over time.

What is Wrong with the Traditional View?

However, the assumption that all investors are equally (and fully) confident about the return process is unlikely to hold in the context of new assets. For instance, sophisticated institutional investors are likely to have more confidence about investing in new assets, especially if they have been investing in these assets for a longer period of time. Consequently, the insights from the traditional literature may not apply. The main contribution of our work is to fill this gap in the literature. In particular, we develop a dynamic general-equilibrium model with two classes of investors, who differ in their confidence about the asset made available by financial innovation: experienced investors, who are fully confident about the new asset (that is, have infinitely precise prior beliefs) and inexperienced investors, such as households, who are relatively less confident (that is, have prior beliefs with finite precision) but learn over time (One might think that inexperienced investors could simply rely on financial advisers. However, when households lack financial expertise, this makes it difficult also to obtain good financial advice). There exist multiple risky assets—a traditional asset representing publicly traded equities plus the new asset—and a risk-free bond. While experienced investors have access to all three financial assets that are available, inexperienced investors can initially trade only the risk-free bond and traditional risky asset, gaining access to the new asset only after financial innovation takes place. Hence, financial markets are incomplete.

We then use this model to demonstrate that if investors differ in confidence, then many of the “intuitive” results in the traditional literature are reversed: financial innovation leads to an increase in the return volatility and risk premium of the new asset along with the volatility of investors’ portfolios. Despite this increase in volatilities, financial innovation increases the welfare of all investors; however, the wealth share of inexperienced investors decreases over time, thereby worsening wealth inequality in contrast to what one would observe if all investors were equally confident. The concentration of investors’ portfolios and the resulting increase in the return volatility and risk premium of the new asset would decline only slowly over several decades, as the inexperienced investors’ confidence increases (that is, their estimate of the dividend-growth rate becomes more precise).

Is Financial Innovation Good or Bad?

In spite of the higher volatility, financial innovation would increase the welfare of all investors because it allows both groups of investors to improve portfolio diversification and enhance risk sharing. However, these gains would not be shared equally…

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