From Wall Street to Main Street: The consequences of financial innovation on international trade and individual risk-bearing

0.1 The effect of financial sophistication on the trade balance. I argue that, all else equal, countries with more sophisticated financial markets will run trade deficits with countries with less sophisticated financial markets. Under autarky, more sophisticated markets allow for better risk sharing, lower demand for precautionary saving, and consequently, higher asset returns in equilibrium. When trade is allowed, capital flows to the country with higher returns, creating trade imbalances. I show that these financial sophistication-induced deficits can persist over time; countries can run trade and current account deficits forever. Anecdotal evidence about the U.S. (which arguably has the most sophisticated financial markets in the world) and Japan (which are considered less-developed by international standards) is consistent with this theory: the two countries have run massive and politically controversial trade and current account imbalances since the early 1970s.;0.2 Estimation of the benefits of financial innovation using micro level data. The financial innovations proposed by Shiller and others are based on aggregate variables like GNP. I ask how valuable are these assets to individuals whose income is not necessarily correlated with aggregate variables. To answer this, I estimate how much the creation of new markets would facilitate risk sharing across individuals. I develop a general equilibrium model that shows that one can value the increase in consumer surplus by measuring the average increase in fit of regressions of individual income on asset returns. I estimate these increases using data from the Panel Study of Income Dynamics (PSID) and the Center for Research on Securities Prices (CRSP) database. I develop a procedure that allows us then to test whether the estimated benefit is significantly different from that of an a priori useless asset.;0.3 A model which allows for the comparison of different levels of market incompleteness. I show that even with undiversifiable risks, restricted participation and incomplete markets, general equilibrium models with agents who solve mean-variance problems can be solved in a simple and intuitive way. Agents hold the two traditional funds of CAPM, the market portfolio and the riskless asset plus a portfolio that minimizes the variation of individual income. Applications to financial innovation and an extension to dynamic models are also shown.;0.4 Are indexed bonds and other proposed financial instruments redundant assets?. Can indexed bonds and other proposed financial innovations like securities which track GDP be synthesized by existing financial markets? The answer is no, in general. This suggests that the indexed bonds, recently advocated by the Clinton administration, will create a genuinely new opportunity for investors. I show this by regressing the returns of new assets on existing assets. I assume that stock returns are generated by a factor model as in the APT of Ross...