Financial Complexity and Trade
|Speaker:||Spyros Galanis, University of Southampton|
|Date: ||Friday 28 October 2016|
|Location: ||Matrix Lecture Theatre, Building One|
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? We show that for smooth convex preferences, including subjective expected utility, complexity cannot halt trade, even in the extreme case where investors are so unsophisticated that they can only trade up to one Arrow-Debreu security, without being able to combine two or more in order to construct a complex trade. For non-smooth preferences, such as maxmin expected utility, complexity can completely shut down trade. In that case, policies that make complex securities easier to understand or investors more sophisticated have a positive welfare effect, as existing gains from trade can now materialize.