Monday, August 26, 2013

The Intuition Behind Simsek's, "Speculation and Risk Sharing with New Financial Assets"

Mark Thoma guides us to an article about a very interesting new finance paper by MIT economist Alp Simsek, “Speculation and Risk Sharing with New Financial Assets” .

If I might take a stab at the intuition:

Suppose you have a world with just two underlying assets, A and B, which are highly negatively correlated.

And there's only one security people can buy. It's 1/2 A and 1/2 B. So everyone has just this security in their portfolios.

Now suppose the financial system becomes more sophisticated, so people can now choose from three securities: Just A, Just B, and 1/2 A and 1/2 B.

If there are sharp disagreements in beliefs about the assets A and B, everyone might go from a portfolio of just 1/2 A and 1/2 B, to a portfolio of either only A, or of only B. So, the average risk of people's portfolios would go up greatly; total risk in the economy would go up greatly; diversification would go down greatly.

Essentially, the more you give people options and ease to gamble based on strong and differing beliefs, the more they will drop some of their diversification and go in and gamble against the people with sharply differing beliefs, like in a winner-take-all-tournament. As Simsek says in the article, “as you increase assets [what I call securities above], this speculative part [of risk] always goes up.”