An evolutionary approach to financial innovation

The purpose of this paper is to explain why some markets for financial prod ucts take off while others vanish as soon as they have emerged. To this end , we model an infinite sequence of CAPM-economies in which financial produc ts can be used for insurance purposes. Agents' participation in these finan cial products, however, is restricted. Consecutive stage economies are link ed by a mapping ("transition function") which determines the next period's participation structure from the preceding period's participation. The tran sition function generates a dynamic process of market participation which i s driven by the percentage of informed traders and the rate at which a new asset is adopted. We then analyse the evolutionary stability of stationary equilibria. In accordance with the empirical literature on financial innova tion, it is obtained that the success of a financial innovation, a mutation , depends on a sufficiently high trading volume, marketing, and new and dif ferentiated hedging opportunities. In particular, a set of complete markets forming a stationary equilibrium is robust with respect to any further fin ancial innovation while this is not necessarily true for a set of incomplet e markets.