Author: Spyros Galanis (University of Southampton)
Paper No 1703
Abstract
What are the implications on trading activity if investors are not sophisticated enough to understand and evaluate trades that have a complex payoff structure? Can frictions generated by this type of financial complexity be so severe that they lead to a complete market freeze, like that of the recent financial crisis? We show that for smooth convex preferences, including subjective expected utility, even extreme complexity cannot halt trade, unlike what happens for non-smooth preferences, such as maxmin expected utility. In the latter case, policies that make complex securities easier to understand or investors more sophisticated have a positive welfare effect, as they allow for existing gains from trade to materialise.