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management services at a much lower cost than

that high-trading-cost individuals can become cus- individuals can provide for themselves. Equilibrium

tomers of low-trading-cost financial intermediaries asset prices will, therefore, reflect the lower marginal

and buy options at nearly the same price as if those transaction costs of those financial-service firms and

individuals could trade continuously without cost. not the higher transaction costs of the individuals.

The underlying force driving the development of Neoclassical portfolio theory also offers some guid-

efficient institutional structures is Adam Smith’s ance in identifying the likely nature of the services

“invisible hand”—firms seeking to maximize their to be provided by financial intermediaries. The the-

profits in competitive product markets. Potential ory of portfolio selection tells us that in the absence

customers have a demand for the contingent pay- of transaction costs and with homogeneous expec-

offs associated with options, and profit-seeking tations, individuals would be indifferent between

financial firms compete to supply the options choosing individually among all assets and choos-

using the lowest-cost technology available to them. ing among a small number of optimized portfolios.

As marginal trading costs for the financial firms This is the classic “separation” theorem of port-

approach zero, equilibrium option prices approach 22

folio theory.

the Black–Scholes dynamic-replication cost. Thus, But in the presence of significant

we should find that with an efficient, well-developed information and transaction costs, the separation

financial system, over time, the neoclassical model theorem turns into an elementary theory of financial

gives the “correct” pricing as a reduced form, but intermediation through mutual funds.

options and other derivative financial instruments

and the institutions that produce them are certainly Mutual funds are the investment intermediaries

19

not redundant. that specialize in producing optimized portfolios

by gathering the information needed (expected

returns, standard deviations, and correlations

4.2 Example 2. Continuous-time portfolio theory among the full set of risky assets) and combining

them in the right proportions (the efficient port-

folio frontier). Because of economies of scale in

Our second example is closely related to the first gathering information, processing it, and trading

one, but carries it a step further. Consider the securities, the transaction costs for mutual funds

Intertemporal CAPM and the assumptions of fric- will be significantly lower than for individuals, so

tionless markets and continuous trading used in

20 individuals will tend to hold mutual funds rather

deriving it. It is well known that by introducing than trade in the individual securities themselves.

transaction costs into a model with an institutional

structure in which individuals all trade for them- This view also addresses the issue of heterogeneous

selves directly in the markets, one can get very expectations in the Capital Asset Pricing Model

different portfolio demand functions and thus very

21 by offering a justifying interpretation for its stan-

different equilibrium prices. But in the presence dard assumption of homogeneous beliefs: namely,

of substantial information and transaction costs it investors in mutual funds in effect “agree to agree”

is not realistic to posit that the only process for indi- with the return-distribution estimates of the pro-

viduals to establish their optimal portfolios is to fessionals who manage those funds. Furthermore,

trade each separate security for themselves directly since professional investors tend to use similar data

in the markets. Instead, individuals are likely to sets and methods of statistical analysis, their esti-

turn to financial organizations such as mutual and mates may be more homogeneous than would

pension funds that can provide pooled portfolio

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otherwise be the case if individuals were gathering

23 life-cycle risk management needs of households.

data and making forecasts directly for themselves. Households today are called upon to make a wide

In more realistically complete models of lifetime range of important and detailed financial deci-

portfolio selection, individuals may have complex sions that they did not have to in the past. For

optimal dynamic strategies. Here too, neoclassical example, in the United States, there is a strong

theory offers a useful starting point for a the- trend away from defined-benefit corporate pen-

ory of financial structure. As shown in Merton sion plans that require no management decisions

(1989), for every dynamic trading strategy there by the employee toward defined-contribution plans

exists an equivalent contingent contract or derivative that do. There are more than 9000 mutual funds

security. Black, Merton, and Scholes derived the and a vast array of other investment products.

option pricing model by showing that there is a Along with insurance products and liquidity assets,

dynamic trading strategy that replicates the pay- the household faces a daunting task to assemble

offs from a call option. That same approach applies

24 these various components into a coherent effective

to any derivative security. The contingent-claim- lifetime financial plan.

equivalence to dynamic portfolio strategies can be

derived by running the option-pricing derivation

25 Some see this trend continuing with existing prod-

“in reverse.” ucts such as mutual funds being transported into

technologically less-developed financial systems.

From contingent-claim-equivalence it follows that Perhaps this is so, especially in the more immedi-

a low-transaction-cost financial intermediary can ate future, with the widespread growth of relatively

sell to high-transaction-cost customers fully hedged inexpensive Internet access to financial “advice

(“immunized”) contracts that have the contin- engines.” However, the creation of all these alter-

gent payoffs associated with an optimized portfolio natives combined with the deregulation that made

strategy. The intermediary pursues the dynamic them possible has consequences: deep and wide-

trading strategy at its lower transaction costs and ranging disaggregation has left households with the

provides the specified contractual payoffs to its

26 responsibility for making important and techni-

customers. cally complex micro-financial decisions involving

risk—such as detailed asset allocation and esti-

Note that under this view of the process of financial mates of the optimal level of life-cycle saving for

intermediation, the products traditionally provided retirement—decisions that they had not had to

by investment management firms tend to merge make in the past, are not trained to make in the

with the long-term contracts traditionally produced present, and are unlikely to execute efficiently in the

by the life insurance industry. This convergence future, even with attempts at education.

transformation has been going on for many years

in the market for variable annuities in the United The availability of financial advice over the Inter-

States, although it has largely been motivated by the net at low cost may help to address some of the

tax-deferral advantages of annuities. information-asymmetry problems for households

with respect to commodity-like products for which

If this view is correct, then as transaction the quality of performance promised is easily ver-

costs continue to decline, financial intermediaries ified. However, the Internet does not solve the

will produce more complicated-to-produce prod- “principal–agent” problem with respect to more

ucts that combine features of investments and fundamental financial advice dispensed by an agent.

insurance. They will be customized to provide

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the production process while neoclassical models

That is why we believe that the future trend will shift remain valid as reduced-form predictors of equi-

toward more integrated financial products and ser- librium asset prices and allocations, we now offer

vices, which are easier to understand, more tailored an example of how behavioral factors can have

toward individual profiles, and permit much more

27 similar effects. As we know from the empirical

effective risk selection and control. studies done by Kahneman, Tversky, and other

behavioral scientists, people’s financial behavior can

Production of the new brand of integrated, cus- differ systematically from the neoclassical assump-

tomized financial instruments will be made eco- tions of rationality. In particular, it has been shown

nomically feasible by applying already existing that when individual choices depend on probabili-

financial pricing and hedging technologies that ties, subjective estimates of these probabilities are

permit the construction of custom products at often subject to large biases. It does not neces-

“assembly-line” levels of cost. Paradoxically, mak- sarily follow, however, that the market prices of

ing the products more user-friendly and simpler products whose demand depends on probability

to understand for customers will create consider- estimates—products such as insurance—will reflect

ably more complexity for their producers. The good those biases. To see why, consider the market for life

news for the producers is that this greater complex- insurance.

ity will also make reverse engineering and “product

knockoffs” by second-movers more difficult and Suppose that people systematically underestimate

thereby, protect margins and create franchise values their life expectancies. Then, if they are risk-averse

for innovating firms. Hence, financial-engineering (or even risk-neutral) the price they will be willing

creativity and the technological and transactional to pay for life insurance will be “too high” relative to

bases to implement that creativity, reliably and the actuarially fair price. For example, suppose that

cost-effectively, are likely to become a central the actuarially fair annual price is $20 per $10,000

competitive element in the industry. of insurance, but people would be willing to pay

$40 as their “reservation” price. What would be the

These developments will significantly change the likely institutional dynamics of price formation in

role of the mutual fund from a direct retail product this market?

to an intermediate or “building block” product

embedded in the more integrated products used Life insurance firms that enter this market early

to implement the consumer’s financial plan. The might earn large profits because they can charge

“fund of funds” is an early, crude example. The the reservation price of $40 while their underwrit-

position and function of the fund in the future ing cost will be the $20 expected loss. But others

will be much like that of individual traded firms will examine the mortality data, calculate the spread

today, with portfolio managers, like today’s CEOs, between price charged and the objective costs of

selling their stories of superior performance to supplying life insurance, and soon discover the

professional fund analysts, who then make rec- profit opportunity available. If there are no effective

ommendations to “assemblers” of integrated retail barriers to the entry of new firms, price competition

financial products. 28

will drive the price to the zero excess-profit point.

4.3 Example 3. Irrational pessimism/optimism Thus, in the long-run, competitive equilibrium,

life insurance prices will reflect the rational unbi-

Having given two examples of how transaction costs ased probabilities of mortality, even though every

can endogenously determine financial structure and buyer of life insurance has biased estimates of

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these probabilities. The institutional structure of neoclassical no-home-bias equilibrium.

providers of this risk-intermediating function and

its dynamics of evolution may be greatly affected Thus, the final equilibrium asset prices and allo-

by this behavioral aberration even though asymp- cations will be as predicted by neoclassical finance

totically it has no effect on equilibrium price and theory. However, the institutional structure in which

once again neoclassical pricing obtains, as a reduced

29 specific financial functions are executed may be

form. materially determined by investor home bias. Of

all possible institutional structures that are consis-

4.4 Example 4. Home bias tent with the neoclassical equilibrium, FSF looks

for the one that most effectively mitigates the dis-

Now consider the well-documented “home-bias”

30 tortionary effects of home bias. Thus, instead of

effect in portfolio selection. Several rational expla- mutual funds and other investment intermediaries

nations for this effect have been proposed in the exclusively serving the function of international

economics and finance literature—for example, diversification on behalf of US residents, home bias

higher information costs for foreign vs. domestic

31 may cause domestically based manufacturing and

shares. But suppose that the reason is indeed an service companies to perform this diversification

irrational bias against investing abroad. Thus, US function through direct investment.

residents prefer to invest in the shares of US corpo-

rations just because they are domiciled in the United Much the same story would be true at a more micro-

States. They, therefore, invest far less abroad than level for regional biases within a country’s borders.

is optimal according to the neoclassical model of For example, Huberman (1999) reports that people

optimal diversification. invest disproportionately in the shares of their local

Bell Operating Systems. Again, we argue that this

Does the posited behavioral “aberration” result behavior does not necessarily lead to a distortion in

in an equilibrium allocation different from the equilibrium prices of shares relative to the neoclas-

neoclassical prediction? sical prediction. However, this behavior would lead

one to predict that Bell operating companies located

Not necessarily. If US corporations were to invest in more investor-rich regions might branch out

only in US capital projects, then with investor home and invest directly in operating companies in other

bias the equilibrium cost of capital and expected less wealthy regions. Cross-regional diversification

return on shares for US companies would be lower would thus be performed by the operating tele-

than in the neoclassical equilibrium, and higher phone companies themselves rather than by mutual

for non-US projects and firms. However, with funds and other “pure” financial intermediaries.

value-maximizing managers and absent legislative

restrictions on investment, this equilibrium is not Note the operation here of the “invisible hand.”

sustainable. With the lower cost of capital for Each individual investor retains his/her home-

the shares of US corporations, US firms will find biased behavior, and firm actions are driven by the

that direct investments abroad will have higher net

32 motive of maximizing net present value, without

present value than domestic ones. Asymptotically requiring any explicit awareness of that behavior.

in the limiting case of no other imperfections except

investor home bias, US corporations would end up Recognition that endogenous institutional changes

issuing shares in the United States and investing may affect the influence of home bias on asset

overseas until they reach an asset allocation and

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“regret insurance,” then investors may be no more

prices, if that bias is behaviorally driven, suggests at risk of realizing regret from paying the premium

some interesting time series tests which compare than from the purchase of other standard forms of

the amounts of stock of companies held directly insurance, such as fire and theft protection on a

by “locals” who are not managers of the firms in house or car.

the 1950s, 1970s, and 1990s. One might expect

that the much larger institutional holdings of stocks Those regret-averse investors who would otherwise

in the latter periods would mitigate the home bias

33 hold sub-optimal portfolio strategies because of

effect. Much the same tests could be applied to strong regret aversion may well be willing to pay a

investments in local mutual fund groups that over premium price for such an option. The theory lay-

time have moved into investing in shares of foreign ing out the production technology and production

companies. cost for an intermediary to create look-back options

first appeared in the scientific literature more than

34 36

4.5 Example 5. Regret aversion two decades ago. Today, look-back options are

available widely over-the-counter from investment

and commercial banks.

Now consider another example from investing to

illustrate how institutions might respond to an irra-

tional behavior pattern by creating new financial The point of this example is to suggest that if

instruments. Suppose that people do indeed have regret aversion is indeed a significant behavioral

an aversion to feeling sorry after-the-fact for earlier phenomenon, then FSF theory predicts an insti-

investment decisions they made. If this behavioral tutional response in the form of creating products

trait is widespread, then we might expect to find a like look-back options. If regret is so widespread

demand in the market for “look-back” options. A that it affects equilibrium prices, then at a given

look-back call option gives its owner the right to buy point in time, one investor’s regret concern about

an underlying security at the lowest price at which selling a security is likely to mirror another investor’s

it traded during the term of the option. Similarly, a regret concern about buying that security. If so,

look-back put option gives its owner the right to sell a properly designed institution or market may be

the underlying security at the highest price at which able to “pair off ” these offsetting demands and neu-

35

it traded during the term of the option. tralize the regret effect on asset demands. Thus,

Thus, by the theoretically predicted incremental effect that

paying a fixed insurance-like premium, the investor this behavioral phenomenon might have had on

is assured of no regret from his investment deci- equilibrium asset prices and allocations in an insti-

sions during the subsequent period covered by the tutional environment without look-back options or

option, because he will buy the stock at the lowest another functionally equivalent institution can be

price (or sell it at the highest price) possible. There mitigated or eliminated entirely with their inclusion

is of course a prospect for regret from paying for 37

by institutionally rational intermediaries.

the option itself, if the ex post gain from the option

does not exceed its cost. However, such regret, if any,

may well be minimal because the premium is fixed 4.6 Example 6. Organizational design

in advance (bounding the amount of regret) and the

“base” price for comparison (if the investor had sold

or bought at some point instead of purchasing the In this example, we move from financial products to

option) is likely to be “fuzzy.” Furthermore, if the consider how organizational design itself might off-

marketing of the option frames it psychologically as set dysfunctional individual behavior and produce

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OBERT ERTON AND VI ODIE to attempt to alter the behavior of the individual

an end result that is in line with neoclassical pre- analyst.

dictions. For example, suppose that when making

investment decisions individually, analysts tend to

be optimistic and overconfident in their forecasts 4.8 Example 8. Sociological elements

38

for the securities they study. Let us suppose fur- 40

of behavioral finance

ther that when individual analysts, each of whom

has studied a different security, are brought together The preceding examples of behavioral distortions of

in a group and asked to form a group consensus efficient risk allocation and asset pricing all involve

regarding all of the securities, the bias is mitigated cognitive dissonance of individual agents. However,

39

or altogether eliminated. there is another dimension of potential behavioral

effects that is sociological in nature in that it derives

FSF theory would predict a strong tendency for from the social structure of the financial system.

asset-management and other financial-service firms Sociological behavior is neither under the control

to organize investment selections as a group process of individuals within that social structure nor a

including creating investment committees to eval- direct consequence of simple aggregation of individ-

uate the recommendations of individual security ual cognitive dysfunctions. A classic instance within

analysts and portfolio managers. The committees 41

finance is the Self-Fulfilling Prophecy (SFP),

would have the effect of mitigating the bias of the applied for instance to bank runs: a bank would

individual analysts. Consequently, there would be remain solvent provided that a majority of its depos-

little or no impact of this individual bias on actual itors do not try to take their money out at the same

investment choices and equilibrium asset market time. However, as a consequence of a public proph-

prices. esy that the bank is going to fail, each depositor

attempts to withdraw his funds and in the pro-

cess of the resulting liquidity crisis, the bank does

4.7 Example 7. Don’t change behavior; solve indeed fail. Each individual can be fully rational

with institutions and understand that if a “run on the bank” does not

occur, it will indeed be solvent. Nevertheless, as a

consequence of the public prophesy, each depositor

Now suppose it were possible to change the behav- decides rationally to attempt to withdraw his sav-

ior of individuals to make them less optimistic ings and the prophecy of bank failure is fulfilled.

and overconfident when analyzing individual secu- As we know, one institutional design used to off-

rities. Although such a change in behavior would set this dysfunctional collective behavior is deposit

eliminate the bias, it might be better not to tin- insurance. There are of course others.

ker with the behavior of individuals. The reason is

that although optimism and overconfidence are dys-

functional in the domain of security analysis, they “Performativity” or Performing Theory has been

may be functional in other domains vital to indi- employed as a mode of analysis with respect to the

vidual success. That is, there can be unintended accuracy of the Black–Scholes option pricing model

and unanticipated consequences of this action. By in predicting market prices of options, exploring

eliminating a person’s optimism and overconfidence whether the model’s widespread public dissemina-

in general, we may therefore do more harm than tion and use by option traders may have actually

good. Thus, it may be considerably better to rely caused market pricing to change so as to make the

42

on investment committees as a means of offsetting model’s predictions become more accurate. Other

the individual bias caused by overconfidence than recent work applying sociological analysis to finance

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5.3 Theory as a predictor of practice

issues includes studies of the sociology of arbitrage

and understanding the development of derivative

43

and other financial markets. As technology progresses and transaction costs con-

tinue to fall, finance theory is likely to provide

increasingly more accurate predictions and prescrip-

5 Elements of functional and structural tions for future product innovations. Combining

finance behavioral theory with neoclassical theory, together

with existing theory within New Institutional Eco-

In this section we review the main analytical ele- nomics, should produce better predictions and

ments of FSF as exemplified by the cases of the prescriptions for the kinds of institutional changes

preceding section. 45

to expect.

5.1 Functions are the “anchors” 5.4 Institutional rationality versus individual

irrationality

When studying the dynamics of financial systems,

it is best to adopt an analytical framework that treats Even when individuals behave in ways that are irra-

functions rather than institutions as the conceptual tional, institutions may evolve to offset this behavior

44

anchors. In this analytical framework the func- and produce a net result that is “as if ” the individ-

tions are exogenous, and the institutional forms are uals were behaving rationally. This is a version of

endogenously determined. Adam Smith’s “invisible hand.” Structural models

that include transactions costs, irrational behavior,

or other “imperfections” may give distorted predic-

5.2 The point of departure is the neoclassical tions when framed in a neoclassical “minimalist”

paradigm institutional setting of atomistic agents interact-

ing directly in markets. It is, therefore, essential

When analyzing changes in parts of the financial sys- to include the endogenous institutional response.

tem, a useful point of departure is the neoclassical Studies of the impact of transactions costs or irra-

paradigm of rational agents operating opportunis- tional behavior patterns would be greatly enhanced

tically in an environment of frictionless markets. if as a matter of format, they included a section

If existing prices and allocations fail to conform to on institutional designs that have the potential to

the neoclassical paradigm, it is helpful to focus on mitigate the effects of these patterns on prices and

why this is so. The possible causes of such a failure allocations. The resulting institutional design, if not

might be: already in place, can be seen as providing either

a prediction about the dynamics of future insti-

• Existing institutional rigidities, in which case tutional change or as a normative prescription for

we might consider applying institutional design innovation.

techniques to circumvent their unintended and

dysfunctional aspects or abolish them directly, if

the institutional sources are no longer needed. 5.5 Synthesis of public and private finance

• Technological inadequacies, which may disap-

pear over time as a result of innovation. The FSF approach has no ideological bias in select-

• Dysfunctional behavioral patterns that cannot be ing the best mix of institutions to use in performing

offset by institutional changes. financial functions. It treats all institutions, whether

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OBERT ERTON AND VI ODIE intermediaries compete with each other in a static

governmental, private-enterprise or family based, as sense and complement each other in a dynamic

potential solutions. The same techniques of finan- sense. That intermediaries and markets compete

cial engineering apply whether the financial system to be the providers of financial products is widely

is dominated by governmental institutions or by recognized. Improving technology and a decline in

private-sector ones or by a balanced mix of the transactions costs has added to the intensity of that

two. FSF seeks to find the best way to perform the competition. Inspection of Finnerty’s (1988, 1992)

financial functions for a given place at a given time. extensive histories of innovative financial products

suggests a pattern in which products offered initially

For example, consider alternative systems for by intermediaries ultimately move to markets. For

financing retirement. In recent years, there has been example:

great interest around the world on this subject, and

big changes are occurring in the institutional means

for providing this essential financial function. In • The development of liquid markets for money

some countries where the economy is primarily instruments such as commercial paper allowed

based on traditional agriculture, retirement income money-market mutual funds to compete with

is provided almost entirely by the retiree’s family. banks and thrifts for household savings.

In other countries it is provided by government, or • The creation of “high-yield” and medium-term

by a mix of government and private-sector pension note markets, which made it possible for mutual

plans. funds, pension funds, and individual investors

to service those corporate issuers who had

This is not by accident. The best institutional struc- historically depended on banks as their source

ture for providing income to the retiree population of debt financing.

varies from country to country, and within a single • The creation of a national mortgage market

country it changes over time. That best structure allowed mutual funds and pension funds to

depends on a country’s demographics, its social and become major funding alternatives to thrift insti-

family structure, its history and traditions, and its tutions for residential mortgages.

stage of economic development. And it changes • Creation of these funding markets also made

with changes in technology. it possible for investment banks and mortgage

brokers to compete with the thrift institutions

These changes in retirement systems are sometimes for the origination and servicing fees on loans

treated as exogenous events or framed as the result and mortgages.

of policy mistakes of the past. Instead, we pro- • Securitization of auto loans, credit-card receiv-

pose that they be viewed systematically as part of ables, and leases on consumer and pro-

a dynamic process of institutional change that can ducer durables, has intensified the competition

be analyzed and improved using the latest financial between banks and finance companies as sources

46

technology. of funds for these purposes.

47 This pattern may seem to imply that successful new

5.6 The financial innovation spiral products will inevitably migrate from intermedi-

aries to markets. That is, once a successful product

The evolution of retirement systems, and indeed becomes familiar, and perhaps after some incentive

the financial system as a whole, can be viewed as an problems are resolved, it will become a commodity

innovation spiral, in which organized markets and

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products encourages investment in creating addi-

traded in a market. Some see this process as destroy- tional markets and products, and so on it goes,

ing the value of intermediaries. However, this spiraling toward the theoretically limiting case of

“systematic” loss of successful products is a conse- zero marginal transactions costs and dynamically

quence of the functional role of intermediaries and complete markets.

is not dysfunctional. Just as venture-capital firms

that provide financing for start-up businesses expect Consider, for example, the Eurodollar futures mar-

to lose their successful creations to capital market ket that provides organized trading in standardized

sources of funding, so do the intermediaries that LIBOR (London Interbank Offered Rate) deposits

create new financial products expect to lose their at various dates in the future. The opportunity

successful and scalable ones to markets. Intermedi- to trade in this futures market provides financial

aries continue to prosper by finding new successful intermediaries with a way to hedge more effi-

products and the institutional means to perform ciently custom-contracted interest-rate swaps based

financial functions more effectively than the exist- on a floating rate linked to LIBOR. A LIBOR

ing ones, all made possible by the commodization rather than a US Treasury rate-based swap is better

of existing products and services. suited to the needs of many intermediaries’ cus-

tomers because their cash-market borrowing rate

Thus, exclusive focus on the time path of indi- is typically linked to LIBOR and not to Treasury

vidual products can be misleading, not only with rates.

respect to the seemingly secular decline in the

importance of intermediation, but with respect At the same time, the huge volume generated by

to understanding the functional relations between intermediaries hedging their swaps has helped make

financial markets and intermediaries. Financial the Eurodollar futures market a great financial suc-

markets tend to be efficient institutional alterna- cess for its organizers. Furthermore, swaps with

tives to intermediaries when the products have relatively standardized terms have recently begun

standardized terms, can serve a large number of to move from being custom contracts to ones

customers, and are well-enough understood for traded in markets. The trading of these so-called

transactors to be comfortable in assessing their “pure vanilla” swaps in a market further expands

prices. Intermediaries are better suited for low- the opportunity structure for intermediaries to

volume customized products. As products such hedge and thereby enables them to create more-

as futures, options, swaps, and securitized loans customized swaps and related financial products

become standardized and move from intermedi- more efficiently.

aries to markets, the proliferation of new trading

markets in those instruments makes feasible the As an example, consider the following issue faced

creation of new custom-designed financial prod- by smaller countries with funded pension plans

ucts that improve “market completeness,” to hedge sponsored by either the government or by pri-

their exposures on those products, the producers vate institutions. Currently, these pension funds

(typically, financial intermediaries) trade in these invest almost entirely in domestic securities—debt

new markets and volume expands; increased vol- and equity issued by local firms, municipalities,

ume reduces marginal transaction costs and thereby and other entities. Although there would appear

makes possible further implementation of more to be significant potential benefits from interna-

new products and trading strategies by interme- tional risk-sharing by pension funds, this has not

diaries, which in turn leads to still more vol- yet happened to any significant extent.

ume. Success of these trading markets and custom

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OBERT ERTON AND VI ODIE contracts all perform fundamentally the same eco-

One way for such international risk-sharing to occur nomic function of risk-transfer, and their prices are

is for the small-country pension funds to invest all linked to each other by a pricing relation that

abroad and for foreign financial institutions to offset rules out arbitrage profits. In this limited sense,

this flow of funds by investing in the small country. given cash or forward or futures contracts, swaps

However, there are significant barriers to such inter- are “redundant.”

national flows of investment funds. Small country

governments fear that the outflows will not be But in the actual world of contemporary inter-

matched by inflows of funds, and therefore impose national finance, small differences in the institu-

restrictions on the amount that pension funds can tional details can have material implications for

invest abroad. At the same time, investors in large the speed of implementation. Futures contracts

countries are reluctant to invest in smaller countries are multilateral-party exchange-traded instruments,

for fear of manipulation and expropriation of their whereas swap contracts are bilateral and are almost

investments. never traded on an exchange. To introduce a new

type of futures contract requires a formal process

To circumvent many of these obstacles and of approval by the governing body of the exchange,

obtain better international diversification, pension representing a consensus of the exchange members,

funds may rely increasingly on international swap

48 which can number in the hundreds. In sharp con-

contracts. A swap contract consists of two parties trast, to introduce a new type of swap contract

exchanging (or “swapping”) a series of payments at requires only consensus between the two coun-

specified intervals (say, every 6 months) over a spec- terparts to the contract. This difference makes it

ified period of time (say, 10 years). The payments possible to innovate and execute new types of swap

are based upon an agreed principal amount (called contracts in a fraction of the time required to

the “notional” amount), and there is no immedi- introduce a new futures contract.

ate payment of money between the parties. Thus,

as in forward and futures contracts, the swap con- Today’s swap contracts also differ from a series

tract itself provides no new funds to either party. of back-to-back loans or forward contracts. Like

The size of each swap payment is the difference swaps, forward contracts are flexible bilateral instru-

between the actual value of the item specified in ments, but they lack a uniform standard. Modern

the contract (e.g., an exchange rate or an interest swap contracts follow a standard format developed

rate) and the value specified in advance in the con- during the early 1980s by the International Swap

tract. International pension swaps would enable a Dealers Association (ISDA). The ISDA’s standard

small country to diversify internationally without

49 contract has been tested in a variety of jurisdictions

violating restrictions on investing capital abroad. around the world. Over the years the document has

been amended and has evolved to meet legal and

Swap contracts provide an excellent example to regulatory requirements virtually everywhere.

illustrate the importance of institutional details

that are routinely ignored in neoclassical analysis. Now that the legal infrastructure has been thor-

As mentioned earlier in this paper, the neoclas- oughly tested and practitioners and regulators have

sical theory of derivatives focuses on the equiva- developed confidence in it, the pace of swap inno-

lences among various combinations of derivatives vation is likely to proceed at a much faster rate

and the underlying assets. Thus, in a frictionless 50

and with much lower transaction costs.

perfect-market environment, leveraged cash mar- With the

ket positions, swaps, forward contracts, and futures infrastructure in place, the cost of implementing

J O I M F Q 2005

OURNAL F NVESTMENT ANAGEMENT IRST UARTER


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DETTAGLI
Corso di laurea: Corso di laurea magistrale in analisi economica delle istituzioni internazionali
SSD:
A.A.: 2011-2012

I contenuti di questa pagina costituiscono rielaborazioni personali del Publisher Atreyu di informazioni apprese con la frequenza delle lezioni di Valutazione e finanziamento dei progetti e studio autonomo di eventuali libri di riferimento in preparazione dell'esame finale o della tesi. Non devono intendersi come materiale ufficiale dell'università La Sapienza - Uniroma1 o del prof Cataldo Alessandro.

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