No. 279 Predicting the Spread of Financial Innovations: An Epidemiological Approach

by Isaiah Hull

October 2013

Abstract

I construct an estimable statistic that predicts whether a financial innovation will spread. The approach embeds the multi-host SIR model from epidemiology within a financial model of correlated securities trade; and takes advantage of the related predictive tools from mathematical epidemiology, including the basic reproductive ratio (R0) and herd immunity. In the model, banks and their creditors are assumed to have imperfect information about a newly-created security, and must search over the portfolios of other investors and intermediaries to infer the security's properties. In the absence of historical returns data, a large mass of firms holding the new security and not experiencing insolvency provides a positive signal about the distribution of its returns within the current period, and perpetuates further holding of the security. The model yields a set of structural equations that are used to construct the statistic. I provide two estimation strategies for the statistic; and identify 12 theoretical parameter restrictions that enable inference when only a subset of the model's parameters are identifiable. I use the approach to predict the spread of exchange traded funds (ETFs) and asset-backed securities (ABS). Additionally, I show how regulators can use the method to monitor the joint solvency of depository institutions within a given geographic region.

Keywords:

Econometric Modeling, Econometric Forecasting, Financial Econometrics, Financial Innovation

JEL Classification:

C510, C530, G140, G120