Heterogeneous Beliefs, Competition, and the Viability of Financial Innovation

This paper studies a dynamic equilibrium model of financial innovation with heterogeneous beliefs and competition among sellers of a new security. We show that both volume and price of the security after it is introduced are sensitive to the differing beliefs of participating players. We present conditions for the innovator to continue issuing the new security and for the imitator to enter the market, and identify scenarios when there is a breakdown in the market with no transactions. We illustrate that the market for forward-type securities is more resilient to the underlying market movement compared to the market for option-type contracts, which is more vulnerable as trades in the security are sensitive to the underlying market condition and may disappear with a drastic market movement. We discuss the implications of our analysis for complex financial instruments, such as tranches of collateralized debt obligations (CDOs).