Financial innovation is a broad term that is used to describe the generation of new and creative approaches to different financial circumstances. The term is sometimes used in relation to the creation of new types of securities. At other times, it has to do with new and interesting approaches to money management or investing. In any situation, financial innovation is all about offering an idea or financial instrument that is different from what has gone before, and has the potential to be extremely desirable in the long run.
There are a number of different theories regarding the basic nature of financial innovation. One approach, known as the Modigliani-Miller theorem, holds that investors should be very concerned about regulatory practices and taxation, and how those factors impact the types of securities that are issued by different entities. The investor should remain relatively unconcerned about any liabilities currently held by the issuing entity.
A different approach to financial innovation is known as the Arrow-Debreu model. This approach takes into consideration a number of external factors, such as political upheavals or natural disasters, and their subsequent impact on various types of financial instruments and the institutions that issue those instruments. The idea is to purchase those securities that will be favorably influenced by these world events, and thus maximize the return.
In the broadest sense, financial innovation is something that takes place on a continuing basis. A number of innovative financial strategies and instruments have come into being since the decade of the 1980s. One example is the creation of interest rate swaps in the early years of that decade, an innovation that allowed many companies and investors to take advantage of the dramatic increase in interest rates that was taking place. In recent years, the development of the credit default swap also allowed businesses to more effectively manage the increasing number of defaults on loans, mortgages, and other forms of credit that took place as the world economy entered into a period of recession.
While many people do recognize the concept of financial innovation, there is no solid agreement of what constitutes a truly new approach, and what is simply a combination of a couple of older approaches that are given a slightly different configuration. The credit default swap of the early 2000s is a prime example, since some would say it is simply the older interest rate swap concept retooled to address a different economic situation.