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Speculation and Risk Sharing with New Financial Assets

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  • Alp Simsek

Abstract

I investigate the effect of financial innovation on portfolio risks when traders have belief disagreements. I decompose traders' average portfolio risks into two components: the uninsurable variance, defined as portfolio risks that would obtain without belief disagreements, and the speculative variance, defined as portfolio risks that result from speculation. My main result shows that financial innovation always increases the speculative variance through two distinct channels: by generating new bets and by amplifying traders' existing bets. When disagreements are large, these effects are sufficiently strong that financial innovation increases average portfolio risks, decreases average portfolio comovements, and generates greater speculative trading volume relative to risk-sharing volume. Moreover, a profit-seeking market maker endogenously introduces speculative assets that increase average portfolio risks. JEL Codes: G11, G12, D53. Copyright 2013, Oxford University Press.

Suggested Citation

  • Alp Simsek, 2013. "Speculation and Risk Sharing with New Financial Assets," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 128(3), pages 1365-1396.
    • Handle: RePEc:oup:qjecon:v:128:y:2013:i:3:p:1365-1396
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    File URL: http://hdl.handle.net/10.1093/qje/qjt007
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    More about this item

    JEL classification:

    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • D53 - Microeconomics - - General Equilibrium and Disequilibrium - - - Financial Markets

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