“Heterogeneous Beliefs, Imitation, and the Vulnerability of Financial Innovation ” by Hong Yan
University of South Carolina
This paper studies a dynamic equilibrium model of financial innovation with heterogeneous beliefs and imitation. We show that both volume and price of the new 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 no transaction in the market. We illustrate that the market for forward-like securities is rather resilient to the underlying market movement, but the market for option-like contracts appears to be more vulnerable as the availability of the security is sensitive to the underlying market condition and may disappear with a drastic market movement.