Financial complexity and trade
Financial complexity and trade
What are the implications on trading activity if investors are not sophisticated enough to understand and evaluate trades that have a complex payoff structure? Can frictions generated by this type of financial complexity be so severe that they lead to a complete market freeze, like that of the recent financial crisis? Starting from an allocation that is not Pareto optimal, we find that whether complexity impedes trade depends on how investors perceive risk and uncertainty. For smooth convex preferences, such as subjective expected utility, complexity cannot halt trade, even in the extreme case where each investor is so unsophisticated that he can only trade up to one Arrow–Debreu security, without being able to combine two or more in order to construct a complex trade. However, for non-smooth preferences, which allow for kinked indifference curves, such as maxmin expected utility, complexity can completely shut down trade.
Agreeable bets, Agreeable trades, Ambiguity aversion, Betting, Financial complexity, Financial crises, No trade
219-230
Galanis, Spyros
66c2b7af-6f28-4319-be60-787796b4054c
November 2018
Galanis, Spyros
66c2b7af-6f28-4319-be60-787796b4054c
Abstract
What are the implications on trading activity if investors are not sophisticated enough to understand and evaluate trades that have a complex payoff structure? Can frictions generated by this type of financial complexity be so severe that they lead to a complete market freeze, like that of the recent financial crisis? Starting from an allocation that is not Pareto optimal, we find that whether complexity impedes trade depends on how investors perceive risk and uncertainty. For smooth convex preferences, such as subjective expected utility, complexity cannot halt trade, even in the extreme case where each investor is so unsophisticated that he can only trade up to one Arrow–Debreu security, without being able to combine two or more in order to construct a complex trade. However, for non-smooth preferences, which allow for kinked indifference curves, such as maxmin expected utility, complexity can completely shut down trade.
Text
financial_complexity_trade
- Accepted Manuscript
More information
Accepted/In Press date: 29 August 2018
e-pub ahead of print date: 31 August 2018
Published date: November 2018
Keywords:
Agreeable bets, Agreeable trades, Ambiguity aversion, Betting, Financial complexity, Financial crises, No trade
Identifiers
Local EPrints ID: 423866
URI: http://eprints.soton.ac.uk/id/eprint/423866
ISSN: 0899-8256
PURE UUID: f430ea15-8dff-4298-8607-4b5313e887f9
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Date deposited: 03 Oct 2018 16:30
Last modified: 16 Mar 2024 07:08
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Author:
Spyros Galanis
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