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Financial Innovation and Asset Price Volatility

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  • Felix Kubler
  • Karl Schmedders

Abstract

We compare asset prices in an overlapping generations model for incomplete and complete markets. Individuals within a generational cohort have heterogeneous beliefs about future states of the economy and thus would like to make bets against each other. In the incomplete-markets economy, agents cannot make such bets. Asset price volatility is very small. The situation changes dramatically when markets are completed through financial innovations as the set of available securities now allows agents with different beliefs to place bets against each other. Wealth shifts across agents and generations. Such changes in the wealth distribution lead to substantial asset price volatility.

Suggested Citation

  • Felix Kubler & Karl Schmedders, 2012. "Financial Innovation and Asset Price Volatility," American Economic Review, American Economic Association, vol. 102(3), pages 147-151, May.
  • Handle: RePEc:aea:aecrev:v:102:y:2012:i:3:p:147-51
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    File URL: http://www.aeaweb.org/articles.php?doi=10.1257/aer.102.3.147
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    References listed on IDEAS

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    1. Huffman, Gregory W, 1987. "A Dynamic Equilibrium Model of Asset Prices and Transaction Volume," Journal of Political Economy, University of Chicago Press, vol. 95(1), pages 138-159, February.
    2. Shafiqur Rahman, 2001. "The Introduction of Derivatives on the Dow Jones Industrial Average and Their Impact on the Volatility of Component Stocks," Journal of Futures Markets, John Wiley & Sons, Ltd., vol. 21(7), pages 633-653, July.
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    Cited by:

    1. Paula Garda & Volker Ziemann, 2014. "Economic Policies and Microeconomic Stability: A Literature Review and Some Empirics," OECD Economics Department Working Papers 1115, OECD Publishing.
    2. Banerjee, Snehal & Graveline, Jeremy J., 2014. "Trading in derivatives when the underlying is scarce," Journal of Financial Economics, Elsevier, vol. 111(3), pages 589-608.
    3. Ricardo J. Caballero & Alp Simsek, 2017. "A Risk-centric Model of Demand Recessions and Macroprudential Policy," NBER Working Papers 23614, National Bureau of Economic Research, Inc.
    4. Hasan Cömert & Gerald Epstein, 2016. "Finansal Yenilik Yazinindaki Son Gelismeler," STPS Working Papers 1604, STPS - Science and Technology Policy Studies Center, Middle East Technical University, revised Jan 2016.
    5. Constantin Laura-Gabriela & Cernat-Gruici Bogdan & Iamandi Irina-Eugenia, 2014. "Investigating Financial Innovation And European Capital Markets. The Case Of Catastrophe Bonds And Listed Reinsurance Companies," Annals - Economy Series, Constantin Brancusi University, Faculty of Economics, vol. 6, pages 6-15, December.

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