Financial Innovation and Risk, the Role of Information

Abstract

Financial innovation has increased opportunities for diversification and lowered investment costs, but has not reduced the relative cost of active (informed) investment strategies compared with passive (less informed) strategies. What are the consequences? I have studied an economy with linear production technologies, some more risky than others. Investors can use low quality public information or collect high quality, but costly, private information. Information helps in avoiding excessively risky investments. Financial innovation lowers the incentives for private information collection and causes a deterioration in public information: the economy more often invests in excessively risky technologies. This changes the properties of the business cycle and can reduce welfare by increasing the likelihood of i?½liquidation crises.