DP13137 The Implications of Financial Innovation for Capital Markets and Household Welfare

Author(s): Adrian Buss, Raman Uppal, Grigory Vilkov
Publication Date: August 2018
Keyword(s): Bayesian learning, differences in beliefs, household finance, household portfolio choice, parameter uncertainty, recursive utility, Wealth Inequality
JEL(s): D53, G11, G12
Programme Areas: Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=13137

Our objective is to understand how financial innovation affects investors' optimal asset-allocation decisions and the economic mechanisms through which these decisions influence financial markets, welfare, and wealth inequality. We show that when some investors, such as households, are less confident than other investors about the dynamics of the new asset made available by financial innovation, but learn over time, many ''intuitive'' results are reversed: financial innovation increases the return volatility and risk premium of the new asset along with volatilities of investors' portfolios. Despite the increase in volatilities, financial innovation improves the welfare of all investors but worsens wealth inequality because experienced investors benefit more from it.