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Financial complexity and trade

Spyros Galanis

Games and Economic Behavior, 2018, vol. 112, issue C, 219-230

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? Starting from an allocation that is not Pareto optimal, we find that whether complexity impedes trade depends on how investors perceive risk and uncertainty. For smooth convex preferences, such as subjective expected utility, complexity cannot halt trade, even in the extreme case where each investor is so unsophisticated that he can only trade up to one Arrow–Debreu security, without being able to combine two or more in order to construct a complex trade. However, for non-smooth preferences, which allow for kinked indifference curves, such as maxmin expected utility, complexity can completely shut down trade.

Keywords: Financial complexity; Financial crises; Agreeable bets; Agreeable trades; No trade; Betting; Ambiguity aversion (search for similar items in EconPapers)
JEL-codes: D70 G01 (search for similar items in EconPapers)
Date: 2018
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DOI: 10.1016/j.geb.2018.08.007

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