ABSTRACT

Finance has been a hotbed for innovation for the past decade. However, most of the innovation has been limited to securitization and bundling of financial claims in a variety of ways. The forces that drove this innovation wave may also have taken us away from market-based economics, in which risk is always priced in a normative fashion. One thing we learned from the recent meltdown of the subprime markets is that there will always be participants who get lazy in assessing the risk and pricing the instruments they are buying and selling. Instruments that bundle risk are complex and if such instruments are transacted among a few players in somewhat inefficient markets, inefficient pricing can prolong for a period of time. However, if the risk is not priced properly, one party in the transaction will pay for it (if not now, then later).