Wednesday, January 15, 2014

All that financial innovation has not lead to more transparency

What is the purpose of financial innovation? I would say it is to find new ways to insure against risk, to finance projects and to allocate funds optimally. We are taught that generally the price mechanism is the best way to do the latter, as long as it is contains all the available information. Thus, a good way to measure whether financial innovation has improved things is to measure whether prices have become more transparent.

Jennie Bai, Thomas Philippon and Alexi Savov take the idea that stock and bond prices should contain information about future earnings. Thus if you regress future earnings on current valuation (and some controls), errors should become smaller over time, because information costs have decreased and we have become more efficient at allocating financial resources. But over the last 50 years, no progress is to report. No matter how you decompose the errors, there is nothing to write home about. That is quite disappointing after all the increased financial sophistication of the financial industry. Or did this sophistication lead to more obfuscation?

1 comment:

Anonymous said...

Efficient markets will oscillate randomly