Speculation and Risk Sharing with New Financial Assets

A. Simsek
2013 Quarterly Journal of Economics  
While the traditional view of ...nancial innovation emphasizes the risk sharing role of new ...nancial assets, belief disagreements about these assets naturally lead to speculation, which represents a powerful economic force in the opposite direction. This paper investigates the e¤ect of ...nancial innovation on risks in an economy when both the risk sharing and the speculation forces are present. I consider this question in a standard CARA-Normal framework. Financial assets provide hedging
more » ... provide hedging services but they are also subject to speculation because traders do not necessarily agree about their payo¤s. I de...ne the average variance of traders' net worths as a measure of ...nancial stability for this economy, and I decompose it into two components: the uninsurable variance, de...ned as the average variance that would obtain if there were no belief disagreements, and the speculative variance, de...ned as the residual variance that results from speculative trades based on belief disagreements. Financial innovation always decreases the uninsurable variance because new assets increase the possibilities for risk sharing. My main result shows that ...nancial innovation also always increases the speculative variance. This is true even if traders completely agree about the payo¤s of new assets. The intuition behind this result is the hedge-more/bet-more e¤ect: Traders use new assets to hedge their bets on existing assets, which in turn enables them to place larger bets and take on greater risks. This e¤ect suggests that ...nancial innovation is more likely to be destabilizing in more complete ...nancial markets and when it concerns derivative assets. In a dynamic setting, ...nancial innovation always reduces the average variance in the long run because traders learn from past asset payo¤s. A question emerges as to how new assets should be introduced to minimize their short run impact on the speculative variance. I show that staggering (or delaying) the introduction of new assets is not e¤ective because it reduces traders'learning simultaneously with their speculation. A viable alternative is to set temporary position limits (or taxes) on new assets.
doi:10.1093/qje/qjt007 fatcat:rrupcd3kvbajdb5u5ucifdjtdq