Financial Innovation and Asset Prices by Grigory Vilkov, Frankfurt School of Finance Management

We study the effects of financial innovation on the asset allocation decisions of experienced and inexperienced investors and the dynamics asset prices. We show that when some investors, such as households, are less well informed about the new asset but learn about it, many “intuitive” results are reversed: financial innovation increases the volatility of investors’ portfolios along with the return volatility and risk premium for the new asset, all of which decline to their pre-innovation levels only slowly. If the new asset is illiquid, shocks to the new asset spill over to the traditional asset, increasing their return correlation and giving rise to a liquidity premium for the new asset. Despite the substantial increase in volatility, financial innovation improves the welfare of both inexperienced and experienced investors.