Sunday, January 29, 2006

Forecasting risk, informed speculation, and financial innovation

How can an exchange maximise profits when informed speculators may drive hedgers out of the market? How do we avoid market failure in these cases? Here two types of market are created - small, stable markets for hedgers and a second larger, volatile market with greater volume that is attractive to speculative trading.

Forecasting risk, informed speculation, and financial innovation: "Speculators who prey on hedgers can stifle financial innovation in the sense that new markets can fail. In this paper I analyze whether a profit maximizing exchange nonetheless chooses to open markets for speculative securities and if so, how to circumvent the problem of market failure. I find that the optimal financial innovation takes two forms. The first is a market structure consisting of hedge instruments, traded in low volume at stable asset prices. The second is a market structure consisting of speculative instruments, traded in greater volume at volatile asset prices. These strategies are derived within the same framework where the cost and the quality of the speculators' information set and the hedgers risk aversion ultimately determine which is the optimal one"

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