We present a standard model of financial innovation, in which intermediaries engineer securities with cash flows that investors seek, but modify two assumptions. First, investors (and possibly intermediaries) neglect certain unlikely risks. Second, investors demand securities with safe cash...

How investor expectations move markets and the economyThe collapse of Lehman Brothers in September 2008 caught markets and regulators by surprise. Although the government rushed to rescue other financial institutions from a similar fate after Lehman, it could not prevent the deepest recession in...

We model a financial market in which investor beliefs are shaped by representativeness. Investors overreact to a series of good news, because such a series is representative of a good state. A few bad news do not change investor minds because the good state is still representative, but enough...