The shadow banking system has spawned an array of financial innovations including mortgage-backed securities products and collateralized debt obligations (CDOs).
One interpretation of the Modigliani–Miller theorem is that taxes and regulation are the only reasons for investors to care what kinds of securities firms issue, whether debt, equity, or something else.
The traditional account of the determinants of financial innovation in economics is the rationalist approach, which is found in Proposition I of the Modigliani and Miller (M&M) irrelevance theory.
The dominant perspective in M&M theory is demand-driven, which overlooks that financial innovations might represent a technological push, meaning they can originate irrespective of market demand reasons.
[8] Following this conclusion, the emphasis has shifted to comprehending the confluence of economic, political, institutional, and technological elements, underpinning innovations.
The capital asset pricing model, first developed by Jack L. Treynor and William Sharpe, suggests that investors should fully diversify and their portfolios should be a mixture of the "market" and a risk-free investment.
The fundamental theorem of finance states that the price of assembling such a portfolio will be equal to its expected value under the appropriate risk-neutral measure.
The extensive literature on principal–agent problems, adverse selection, and information asymmetry points to why investors might prefer some types of securities, such as debt, over others like equity.
In these circumstances, they find that the traditional split of cash flows between debt and equity is not optimal, and that state-contingent securities are preferred.
From a sociological point of view, some economists argue that mathematical formulas actually change the way that economic agents use and price assets.
Economists, rather than acting as a camera taking an objective picture of the way the world works, actively change behavior by providing formulas that let dispersed agents agree on prices for new assets.
[6] The Modigliani–Miller theorem explicitly considered taxes as a reason to prefer one type of security over another, despite that corporations and investors should be indifferent to capital structure in a fractionless world.
Some investors use total return swaps to convert dividends into capital gains, which are taxed at a lower rate.
In the United States, Regulation Q drove several types of financial innovation to get around its interest rate ceilings, including eurodollars and NOW accounts.
Households need to keep lower cash balances—if the economy exhibits cash-in-advance constraints then these kinds of financial innovations can contribute to greater efficiency.
[19] The first ones help inexperienced investors gain expertise and knowledge, for example, by copy trading, which allows them to imitate top-performing traders' portfolios (e.g., eToro, Estimize, Stocktwits).
The second option allows investors with minimum technical skills to build, backtest, and implement trading algorithms, which they may then share with others (Streak, Quantopian & Zipline, Numerai).
[23] According to the traditional innovation-growth theory, financial innovations assist in increasing the quality and diversity of banking services, allow risk sharing, complete the market, and, ultimately, improve allocative efficiency.