This paper analyses the accuracy of replicating portfolio methods in predicting asset prices. In a two-period, general equilibrium model with incomplete financial markets and heterogeneous agents, a computational study is conducted under various distributional assumptions. We focus on the price of a call option on an underlying risky asset. There is evidence that the value of the (approximate) replicating portfolio is a good approximation for the general equilibrium price for CRRA preferences, but not for CARA preferences. Furthermore, there is strong evidence that the introduction of the call option reduces market incompleteness and that the price of the underlying asset is unchanged. There is, however, inconclusive evidence on whether the availability of the option increases agents' welfare.
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Paper provided by Department of Economics, University of York in its series Discussion Papers with number
07/16.
Length: Date of creation: Jun 2007 Date of revision: Handle: RePEc:yor:yorken:07/16
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