Decision-making And Equilibrium Models Of Financial Innovation Under Different Market Structures

The traditional literature on financial innovation usually focus on the motivations, characteristics, and processes (including innovation and diffusion processes) of financial innovation. In fact, financial innovation, especially financial product innovation, can be considered as some kind of investment, when the behavior of the agents involved is considered. The agents are rational, and they make choice. Due to the existence of uncertainty, it is logical to say that financial innovation involves investment under uncertainty. Thus, it is necessary to analyze the investment decision-making under uncertainty when dealing with the process of financial innovation.This paper analyzes theoretically the financial innovations and the equilibria in subsequent markets, based on the framework of the traditional real options and option games literature, and thus provides a new analysis and valuation framework for financial innovation decision-making. Addition to an array of theoretical models, some simple numerical results are calculated in order to make the models more understandable.First, this paper builds a valuation model of innovation with monopoly under uncertainty. Assuming that the project value follows an exogenous stochastic process, the model calculates the optimal timing and the threshold of the innovation. As the results show, the more uncertain the future profits are, the more valuable the innovation option is. Further, the project value is considered as a function of the output price, and then valuates the option and finds the optimal timing and threshold. The results show that if operational costs are considered, the project value and option value will have different characteristics within different areas of price.Then, under perfectly competitive situation, this paper models the decision-making and equilibrium of the innovations of competitive firms. Compared with the monopoly case, the entry price of a competitive firm is identical to that of a monopoly. Solving a dynamic programming problem of a central planner can prove that the competitive equilibrium and the social optimum is identical.Finally, a symmetrical duopoly model with incomplete competition is provided andanalyzed. By calculating and analyzing the follower value, the leader value, and their thresholds, tine model guarantees that a mixed strategy equilibrium exist.