We study the effects of financial innovation in a model of endogenous information acquisition. We determine the conditions under which the introduction of a derivative written on an existing stock increases or decreases the incentive to purchase information. We show that financial innovation produces some effects which hold across informational structures and others which differ. The former coincide with the few empirical results that are robust in the literature (effects on prices, risk premia, and volatility), while the latter coincide with the ones that differ experiment by experiment (effects on volume, correlation between volume and volatility, and market informational efficiency).

We study the effects of financial innovation in a model of endogenous information acquisition. We determine the conditions under which the introduction of a derivative written on an existing stock increases or decreases the incentive to purchase information. We show that financial innovation produces some effects which hold across informational structures and others which differ. The former coincide with the few empirical results that are robust in the literature (effects on prices, risk premia, and volatility), while the latter coincide with the ones that differ experiment by experiment (effects on volume, correlation between volume and volatility, and market informational efficiency).

We use a two-year panel of individual accounts in an S&P 500 index mutual fund to examine the trading and investment behavior of more than 91 thousand investors who have chosen a low-cost, passively managed vehicle for savings.This allows us to characterize investors' heterogeneity in terms of their investment patterns.In particular, we identify positive feedback traders as well as contrarians whose activities are conditional upon preceding day stock market moves.We test the consistency and profitability of these conditional strategies over time.We find that more frequent traders are typically contrarians, while infrequent traders are more typically momentum investors.The dynamics of these investor classes help us to partially examine the question of the marginal investor over the period of our study.We find that the behavior of momentum investors is typically more correlated to changes in the S&P 500 and we trace its dynamics over time.We build up "behavioral factors" based on contrarian and momentum flows and show that they perform well against a benchmark of loadings on latent factors extracted from returns.We also use the behavior of momentum and contrarian investors to build a measure of "market polarization".This captures the dispersion of beliefs among the investors and helps to account for asset pricing better than standard measures of dispersion of beliefs.