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Excess price volatility and financial innovation

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  • Alessandro Citanna

    ()

  • Karl Schmedders

Abstract

In a three-period finite exchange economy with incomplete financial markets and retrading, we study the effects of the degree of incompleteness and of changes in the financial structure on asset price volatility. In what are essentially no aggregate risk economies, asset price volatility is a sunspot-like phenomenon. If markets are completed by financial innovation, asset price volatility reduction is generic. With aggregate risk, changes in the financial structure affect asset price volatility through a pecuniary externality. Financial innovation which decreases equilibrium price volatility can be crafted under conditions of sufficient market incompleteness. Numerical examples illustrate the role of risk aversion for volatility changes and show that, with or without aggregate risk, reducing the degree of incompleteness per se is not necessarily associated with a volatility reduction. Copyright Springer-Verlag Berlin/Heidelberg 2005

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File URL: http://hdl.handle.net/10.1007/s00199-004-0532-2
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Bibliographic Info

Article provided by Springer in its journal Economic Theory.

Volume (Year): 26 (2005)
Issue (Month): 3 (October)
Pages: 559-587

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Handle: RePEc:spr:joecth:v:26:y:2005:i:3:p:559-587

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Related research

Keywords: Incomplete markets; Financial innovation; Volatility.;

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Cited by:
  1. Florian Wagener & Cars Hommes & William Brock, 2006. "More hedging instruments may destabilize markets," Working Papers wp06-11, Warwick Business School, Financial Econometrics Research Centre.
  2. Helios Herrera, 2005. "Sorting in Risk-Aversion and Asset Price Volatility," Levine's Bibliography 172782000000000083, UCLA Department of Economics.
  3. Rosser Jr., J. Barkley, 2010. "Is a transdisciplinary perspective on economic complexity possible?," Journal of Economic Behavior & Organization, Elsevier, vol. 75(1), pages 3-11, July.
  4. Brock, W.A. & Hommes, C.H. & Wagener, F.O.O., 2008. "More hedging instruments may destabilize markets (Revised version, April 2008)," CeNDEF Working Papers 08-04, Universiteit van Amsterdam, Center for Nonlinear Dynamics in Economics and Finance.
  5. Laura Angeloni & Bernard Cornet, 2005. "Existence Of Financial Equilibria In A Multiperiod Stochastic Economy," WORKING PAPERS SERIES IN THEORETICAL AND APPLIED ECONOMICS 200506, University of Kansas, Department of Economics, revised Feb 2005.
  6. Bhamra, Harjoat Singh & Uppal, Raman, 2006. "The Effect of Introducing a Non-redundant Derivative on the Volatility of Stock-Market Returns," CEPR Discussion Papers 5726, C.E.P.R. Discussion Papers.

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