Tuesday, August 27, 2013

A New Perspective on Financial Innovation and Risk

While the traditional view of financial innovation emphasizes the risk sharing role of new financial assets, belief disagreements about these assets naturally lead to speculation, which represents a powerful economic force in the opposite direction.

Theoretically, financial innovation should make markets safer by spreading risk across a wider and deeper population of investors, rather than concentrating it in the hands of a relative few.  A study published by MIT economist and assistant professor Alp Simesk, however, concludes that the opposite is true: financial innovation does not lower portfolio risk.  Rather Simesk finds that financial innovation creates opportunities for investors to take risks, or bets, on opposing sides of deep disagreements about the value of certain investments. Simesk concludes that this actually magnifies and multiplies risk rather than reducing it.   “In a world in which investors have different views, new securities won’t necessarily reduce risks,” says Simsek. “People bet on their views. And betting is inherently a risk-increasing activity.”

In a paper published in August in the Quarterly Journal of Economics, titled “Speculation and Risk Sharing with New Financial Assets,” Simsek details how he came to this conclusion. The risk in portfolios, he argues, needs to be divided into two categories: the kind of risk that is simply inherent in any real-world investment, and a second type he calls “speculative variance,” which applies precisely to new financial instruments designed to generate bets based on opposing worldviews.

Simesk's paper demonstrates mathematically the idea that, using this widely accepted mode of analyzing risk, “as you increase assets, this speculative part always goes up,” and “when disagreements are large enough, this second effect is dominant and you end up increasing the average [portfolio risks] as well.”

Despite his conclusions on risk, Simesk believes that financial innovation does have value.  It increases the amount of financial information available, thus reducing price variances and overall prices.  However, innovation as a tool of risk reduction, according to Simesk, is logically and factually flawed.  

Simesk's final paper is available for subscribers of the "Quarterly Journal of Economics" at: http://qje.oxfordjournals.org/content/128/3/1365.full

Earlier drafts of Mr. Simesk's paper can be read at: http://bfi.uchicago.edu/events/20120510_macrofragility/papers/simsek_speculation.pdf  and