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
JEL(s): G11, G12
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.