Financial Innovation and Arbitrage Pricing in Frictional Economies

Abstract

Frictional economies are fundamentally different from their frictionless counterparts. For example, in frictional economies, the price function is sublinear and thus there will be incentives to innovate. When decomposing existing securities and opening new markets, innovators serve important economic functions, such as allowing investors to obtain consumption at lower costs, enabling investors to achieve better risk sharing, and making the fundamental value of more payoffs observable. In particular, innovators serve these functions even when they introduce redundant securities that are not yet issued. Furthermore, in frictional economies, the replication-based arbitrage valuation approach tends to overprice certain securities while underpricing others. Journal of Economic Literature Classification Numbers: C61, G10, G12, G20. © 1995 Academic Press. All rights reserved.