DP12416 Financial Innovation and Asset Prices
|Author(s):||Adrian Buss, Raman Uppal|
|Publication Date:||November 2017|
|Keyword(s):||differences in beliefs, parameter uncertainty, rational learning, recursive utility, spillover effects|
|Programme Areas:||Financial Economics|
|Link to this Page:||www.cepr.org/active/publications/discussion_papers/dp.php?dpno=12416|
We study the effects of financial innovation on the dynamics of asset prices. We show that when some investors are less well informed about the new asset but rationally learn about it, many "intuitive'' results are reversed: financial innovation increases the volatility of investors' portfolios along with the return volatility and risk premium for the new asset, which decline to their pre-innovation levels only slowly. Moreover, illiquidity of the new asset causes shocks to the new asset to spill over to the traditional asset, increasing their return correlation and giving rise to a liquidity premium for the new asset.