Financial Innovation

A detailed Summary of Financial Innovation

Change is inevitable. Whether in life or in business, adaption must take place in order to survive and thrive. Financial innovation is an example of business evolution where firms develop instruments that are more efficient at redistributing risk from those who are unwilling to bear to those who are willing (M. Miller, 1986). There are some experts that believe financial innovation was invented to avoid tax rules and regulations. Although, this is not a as popular an opinion as the prior theory, it is likely there is some truth to both viewpoints. It is widely believed there are six primary causes for financial innovation, they are:

1. Increased volatility of interest rates, inflation, equity prices, and exchange rates.

2. Advances in computer and telecommunications technologies.

3. Greater sophistication and educational training among professional market participants.

4. Financial intermediary competition.

5. Incentives to get around existing tax laws.

6. Changing global patterns of financial wealth.

Financial innovation can also be classified in three main categories. Market broadening instruments, which increase market liquidity and availability of funds; risk management instruments, which redistribute financial r

isk to those who are more willing to bear the risk; and arbitraging instruments and processes, which allow the investor to take advantage of certain market perceptions such as information, taxation and regulation (Fabozzi, 2001). No matter the cause or category of the financial innovation the industry will benefit if the innovation stands the test of time and improves upon the efficiency of the financial market.

Similar to asset securitization, derivatives are another important financial innovation that was developed to reduce credit risk and the risk of price fluctuations in certain industries. Firms will be able to transfer risk, to those more willing to bear, and sell the division to those more willing market participants. In an effort to hedge risk and increase efficiency and stability options, futures, and forwards are used. Markets that are prone to times of instability benefit most from derivatives might include the currency, energy, commodity, and interest rate markets (Bies, 2002).

It is evident that financial innovation is a method for financial markets to evolve into a more efficient and attractive industry. Innovation can appear in the form of product packaging (mutual funds or asset securitization) or technological development (computer assisted asset trading). It does not matter how or where the innovation originated, as long as the innovation promotes behaviors like borrowers

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Approximate Word count = 950
Approximate Pages = 4 (250 words per page double spaced)

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