Speculative Financial Innovation

We analyze how speculative financial innovation affects stock prices, risk premiums, market liquidity, and investor welfare in an economy with heterogeneous beliefs. When investors disagree about the covariance of the newly introduced stocks with the original stocks, we show that financial innovation reduces the variance-covariance matrix of the representative investor, which decreases the market portfolio's risk premium. When investors disagree on the expected payoff of the new stocks, the representative investor's expected payoff of the existing stocks can also change due to hedging demands among investors, which causes the stock prices to change. Financial innovation further causes the market liquidity to increase as prices will be less sensitive to supply shocks due to the reduced variance-covariance matrix of the representative investor. Finally, we show that financial innovation could make all investors better off under their own beliefs but worse off under the true beliefs