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The Effect of Introducing a Non-Redundant Derivative on the Volatility of Stock-Market Returns When Agents Differ in Risk Aversion

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  • Harjoat S. Bhamra
  • Raman Uppal

Abstract

We study the effect of introducing a nonredundant derivative on the volatilities of the stock market return and the locally risk-free interest rate. Our analysis uses a standard, frictionless, full-information, dynamic, continuous-time, general-equilibrium, Lucas endowment economy in which there are two classes of agents who have time-additive power utility functions and differ only in their risk aversion. Our main result is to show analytically that if the intensity of the precautionary demand for savings is not too high, then the introduction of a nonredundant derivative increases the volatility of stock market returns. Furthermore, in the economy with the derivative, the volatility of stock market returns can be substantially greater than that of aggregate dividend growth (fundamental volatility). We also show that the volatility of the locally risk-free interest rate increases with the introduction of the derivative. The Author 2007. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For permissions, please email: journals.permissions@oxfordjournals.org., Oxford University Press.

Suggested Citation

  • Harjoat S. Bhamra & Raman Uppal, 2009. "The Effect of Introducing a Non-Redundant Derivative on the Volatility of Stock-Market Returns When Agents Differ in Risk Aversion," Review of Financial Studies, Society for Financial Studies, vol. 22(6), pages 2303-2330, June.
  • Handle: RePEc:oup:rfinst:v:22:y:2009:i:6:p:2303-2330
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    File URL: http://hdl.handle.net/10.1093/rfs/hhm076
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    Cited by:

    1. Cvitanic, Jaksa & Malamud, Semyon, 2011. "Price impact and portfolio impact," Journal of Financial Economics, Elsevier, vol. 100(1), pages 201-225, April.
    2. Weinbaum, David, 2010. "Preference heterogeneity and asset prices: An exact solution," Journal of Banking & Finance, Elsevier, vol. 34(9), pages 2238-2246, September.
    3. 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.
    4. Wei Xiong & Hongjun Yan, 2010. "Heterogeneous Expectations and Bond Markets," Review of Financial Studies, Society for Financial Studies, vol. 23(4), pages 1433-1466, April.
    5. Tran, Ngoc-Khanh & Zeckhauser, Richard, 2011. "The Behavior of Savings and Asset Prices When Preferences and Beliefs are Heterogeneous," Working Papers 11-44, University of Pennsylvania, Wharton School, Weiss Center.
    6. François Grand & Xavier Ragot, 2016. "Incomplete markets and derivative assets," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 62(3), pages 517-545, August.
    7. Chabakauri, Georgy, 2010. "Asset pricing with heterogeneous investors and portfolio constraints," LSE Research Online Documents on Economics 43142, London School of Economics and Political Science, LSE Library.
    8. Dimitri Vayanos & Peter Kondor, 2014. "Liquidity Risk and the Dynamics of Arbitrage Capital," 2014 Meeting Papers 912, Society for Economic Dynamics.
    9. Harjoat S. Bhamra & Raman Uppal, 2014. "Asset Prices with Heterogeneity in Preferences and Beliefs," Review of Financial Studies, Society for Financial Studies, vol. 27(2), pages 519-580.
    10. Roman Muraviev, 2013. "Market selection with learning and catching up with the Joneses," Finance and Stochastics, Springer, vol. 17(2), pages 273-304, April.
    11. Judd, Kenneth L. & Leisen, Dietmar P.J., 2010. "Equilibrium open interest," Journal of Economic Dynamics and Control, Elsevier, vol. 34(12), pages 2578-2600, December.
    12. Chabakauri, Georgy & Rytchkov, Oleg, 2014. "Asset pricing with index investing," LSE Research Online Documents on Economics 60739, London School of Economics and Political Science, LSE Library.
    13. Idan Hodor & Andrea Buffa, 2017. "Institutional Investors, Heterogeneous Benchmarks and the Comovement of Asset Prices," 2017 Meeting Papers 374, Society for Economic Dynamics.
    14. Arısoy, Yakup Eser & Altay-Salih, Aslıhan & Pınar, Mustafa Ç, 2014. "Optimal multi-period consumption and investment with short-sale constraints," Finance Research Letters, Elsevier, vol. 11(1), pages 16-24.
    15. Roche, Hervé, 2011. "Asset prices in an exchange economy when agents have heterogeneous homothetic recursive preferences and no risk free bond is available," Journal of Economic Dynamics and Control, Elsevier, vol. 35(1), pages 80-96, January.
    16. Agostino Capponi & Martin Larsson, 2011. "Default and Systemic Risk in Equilibrium," Papers 1108.1133, arXiv.org, revised Dec 2011.

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