While the traditional view of financial innovation emphasizes the risk sharing role of new fi 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 effect of fi 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 services but they are also subject to speculation because traders do not necessarily agree about their payoffs. I de fine the average variance of traders net worths as a measure of financial stability for this economy, and I decompose it into two components: the uninsurable variance, de fined as the average variance that would obtain if there were no belief disagreements, and the speculative variance, de fined 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 financial innovation also always increases the speculative variance. This is true even if traders completely agree about the payoffs of new assets. The intuition behind this result is the hedge-more/bet-more effect: 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 effect suggests that financial innovation is more likely to be destabilizing in more complete financial markets and when it concerns derivative assets.
In a dynamic setting, financial innovation always reduces the average variance in the long run because traders learn from past asset payoffs. 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 effective because it reduces traders learning simultaneously with their speculation. A viable alternative is to set temporary position limits (or taxes) on new assets.
If there was a “Fantasy Economics League,” I would go long on this guy. For the pointer I thank Tristan.