A framework for analyzing the process of financial innovation

The following note presents a framework for analyzing financial management techniques and financial product innovation. The framework attempts to illustrate how characteristics of the economic system and its participants motivate financing needs and encourage innovations in financing techniques. New sets of financial contracts are the joint product of (1) changes in technology and in the inter­national macro environment of asset prices; (2) the interplay of individual market participant's existing financial exposures; and (3) the presence of fruitful cross-market arbitrage opportunities based on differing national jurisdictions and structures. We use stylized examples to explore several different manifestations of this process and we offer general observations on how financial innovation may change the character of international money and credit markets. Finally, in thinking about official attitudes toward the process of innovation policies, it is necessary to form a view of the counterfactual world. How would the world economies have functioned without innovation?