City Research Online

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.

Publication Type:	Article
Additional Information:	© Elsevier 2019. This manuscript version is made available under the CC-BY-NC-ND 4.0 license http://creativecommons.org/licenses/by-nc-nd/4.0/
Publisher Keywords:	Financial complexity, Financial crises, Agreeable bets, Agreeable trades, No tradeBetting, Ambiguity aversion
Subjects:	H Social Sciences > HB Economic Theory H Social Sciences > HF Commerce
Departments:	School of Policy & Global Affairs > Economics
SWORD Depositor:	Symplectic Administrator

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