FIN-02-042

Financial Innovation, Market Participation and Asset Prices

March 2002

Laurent Calvet, Martín Gonzalez-Eiras and Paolo Sodini

ABSTRACT
This paper theoretically investigates the pricing e .ects of financial innovation in an economy with endogenous participation and hetero-geneous income risks. The introduction of non-redundant assets can endogenously modify the participation set, reduce the covariance be-tween dividends and participants’ consumption and thus lead to lower risk premia. This mechanism is demonstrated in a tractable exchange economy with a finite number of macroeconomic factors. Agents can freely borrow and lend, but must pay a fixed entry cost to invest in risky assets. Security prices and the participation structure are jointly determined in equilibrium. The model is consistent with several fea-tures of financial markets over the past few decades: substantial finan-cial innovation; a sharp increase in investor participation; improved risk management practices; a slight increase in interest rates; and a reduction in risk premia.

Laurent Calvet
Institution: Stern School of Business, New York University, 44 West 4th Street, New York, NY 10012
Email: lcalvet@stern.nyu.edu
Homepage:http://www.stern.nyu.edu/~lcalvet

Martín Gonzalez-Eiras
Institution: De-partamento de Economía, Vito Dumas 284 (1644) - Victoria, Buenos Aires, Argentina,
Email: mge@udesa.edu.ar

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