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Rev Fin 1998; 11:739-755
© 1998 the Society for Financial Studies

Article

Arbitrage, hedging, and financial innovation

J Dowz
European University Institute, Badia Fiesolana, I-50016 San Domenico di Fiesole (FI), Italy
e-mail: dow@datacomm.iue.it
z Address from Jan 1999: London Business School, Sussex Place, Regents Park, London NW1 4SA, UK
e-mail: jdow@lbs.ac.uk

Abstract

I consider the costs and benefits of introducing a new security in a standard framework where uninformed traders with hedging needs interact with risk-averse informed traders. Opening a new market may make everybody worse off, even when the new security is traded in equilibrium. This article emphasizes cross-market links between hedging and speculative demands: risk-averse arbitrageurs can use the new market to hedge their positions in the preexisting security, which can affect liquidity in the old market. More generally, the availability of such hedging opportunities will influence the strategies to which traders will direct resources.


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