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More hedging instruments may destabilize markets (Revised version, April 2008)

  • Brock, W.A.
  • Hommes, C.H.
  • Wagener, F.O.O.

    ()

    (Universiteit van Amsterdam)

This paper formalizes the idea that more hedging instruments may destabilize markets when traders have heterogeneous expectations and adapt their behavior according to experience based reinforcement learning. In a simple asset pricing model with heterogeneous beliefs the introduction of additional Arrow securities may destabilize markets, and thus increase price volatility, and at the same time decrease average welfare. We also investigate whether a fully rational agent can employ additional hedging instruments to stabilize markets. It turns out that the answer depends on the composition of the population of non-rational traders and the information gathering costs for rationality.

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File URL: http://www1.fee.uva.nl/cendef/publications/papers/arrowabridged.pdf
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Paper provided by Universiteit van Amsterdam, Center for Nonlinear Dynamics in Economics and Finance in its series CeNDEF Working Papers with number 08-04.

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Date of creation: 2008
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Handle: RePEc:ams:ndfwpp:08-04
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Dept. of Economics and Econometrics, Universiteit van Amsterdam, Roetersstraat 11, NL - 1018 WB Amsterdam, The Netherlands

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