An Inquiry Into Recent Financial Innovation

Study on Financial Innovations Financial innovations are the result of inefficient and imperfect financial markets. Reduced costs of financial intermediation in the wake of financial innovations help to make the overall allocation of savings capital more efficient. (Examples: development of the Eurodollar market with the consequence of narrowing interest spreads as well as the latest phenomenon of securitization.) Financial innovations also reduce the imperfections of financial markets on which the existing financial instruments are not in a position to meet all the requirements of market participants. On imperfect markets it is possible to obtain higher prices for the satisfaction of such requirements than in perfect markets with balanced competition. (Example: introduction of the zerobond in the 1980s.) Financial innovations, which do not increase the efficiency and perfection of financial markets, are without substance in economic terms. They owe their existence to irrational modes of behaviour or excessive speculation by market participants. In the author’s opinion, they will always be shortlived. The causes for the inefficiency and imperfection of financal markets are varied. For example, causes of financial innovations have been regulatory changes, tax law amendments, changes in the level of economic activity, interest and exchange rate modifications, and technological progress, especially in the communications technology. Enormously increased interest rate and currency risks that cannot be shifted with the requisite ease and cost-effectiveness and are the result of the volatility of interest and exchange rates have resulted in a number of important innovations. Interest and exchange rate swaps, interest rate futures contracts and options have substantially widened the scope for the allocation of such risks. In order to contain the interest rate fluctuation risk, different hedging practices, i.e. interest rate futures contracts and options, are treated in the same way as variable interest rate loans, which carry a maximum interest rate or fluctuate within a maximum margin. With the help of the option price theory, the maximum interest value is reflected as a function of the variability of future interest rates