The Effect of Introducing a Non-redundant Derivative on the Volatility of Stock-Market Returns
We study the effect of introducing a new security, such as a non-redundant derivative, on the volatility of stock-market returns. Our analysis uses a standard, continuous time, dynamic, general-equilibrium, full-information, frictionless, Lucas endowment economy where there are two classes of agents who have time-additive power utility functions and differ only in their risk aversion. We solve for equilibrium in two versions of this economy. In the first version, risk-sharing opportunities are limited because investors can trade in only the market portfolio, which is a claim on the aggregate endowment. In the second version, agents can trade in both the market portfolio and a new zero-net-supply derivative. We show analytically that for a sufficiently small precautionary-savings effect, the introduction of a non-redundant derivative on the market increases the volatility of stock-market returns.
If you experience problems downloading a file, check if you have the proper application to view it first. In case of further problems read the IDEAS help page. Note that these files are not on the IDEAS site. Please be patient as the files may be large.
As the access to this document is restricted, you may want to look for a different version under "Related research" (further below) or search for a different version of it.
|Date of creation:||Jun 2006|
|Contact details of provider:|| Postal: Centre for Economic Policy Research, 77 Bastwick Street, London EC1V 3PZ.|
Phone: 44 - 20 - 7183 8801
Fax: 44 - 20 - 7183 8820
|Order Information:|| Email: |
References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- Detemple, Jerome B & Selden, Larry, 1991. "A General Equilibrium Analysis of Option and Stock Market Interactions," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 32(2), pages 279-303, May.
- Gennotte, Gerard & Leland, Hayne, 1990.
"Market Liquidity, Hedging, and Crashes,"
American Economic Review,
American Economic Association, vol. 80(5), pages 999-1021, December.
- Gerard Gennotte and Hayne Leland., 1989. "Market Liquidity, Hedging and Crashes," Research Program in Finance Working Papers RPF-192, University of California at Berkeley.
- Gerard Gennotte and Hayne Leland., 1989. "Market Liquidity, Hedging and Crashes," Research Program in Finance Working Papers RPF-184, University of California at Berkeley.
- Franke, Gunter & Stapleton, Richard C. & Subrahmanyam, Marti G., 1998. "Who Buys and Who Sells Options: The Role of Options in an Economy with Background Risk," Journal of Economic Theory, Elsevier, vol. 82(1), pages 89-109, September.
- Brennan, Michael J & Schwartz, Eduardo S, 1989. "Portfolio Insurance and Financial Market Equilibrium," The Journal of Business, University of Chicago Press, vol. 62(4), pages 455-472, October.
- Leland, Hayne E, 1980. " Who Should Buy Portfolio Insurance?," Journal of Finance, American Finance Association, vol. 35(2), pages 581-594, May.
- Hayne E. Leland., 1979. "Who Should Buy Portfolio Insurance?," Research Program in Finance Working Papers 95, University of California at Berkeley.
- Heaton, John & Lucas, Deborah J, 1996. "Evaluating the Effects of Incomplete Markets on Risk Sharing and Asset Pricing," Journal of Political Economy, University of Chicago Press, vol. 104(3), pages 443-487, June.
- John Heaton & Deborah Lucas, 1993. "Evaluating the Effects of Incomplete Markets on Risk Sharing and Asset Pricing," NBER Working Papers 4249, National Bureau of Economic Research, Inc.
- Huang, Jennifer & Wang, Jiang, 1997. "Market Structure, Security Prices, And Informational Efficiency," Macroeconomic Dynamics, Cambridge University Press, vol. 1(01), pages 169-205, January.
- Alessandro Citanna & Karl Schmedders, 2005. "Excess price volatility and financial innovation," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 26(3), pages 559-587, October.
- Alessandro Citanna & Karl Schmedders, 2005. "Excess price volatility and financial innovation," Post-Print hal-00480119, HAL.
- Jerome B. Detemple, 1990. "Financial Innovation, Values and Volatilities when Markets Are Incomplete*," The Geneva Risk and Insurance Review, Palgrave Macmillan;International Association for the Study of Insurance Economics (The Geneva Association), vol. 15(1), pages 47-53, March.
- Domenico Cuoco & Hua He, 2001. "Dynamic Aggregation and Computation of Equilibria in Finite-Dimensional Economies with Incomplete Financial Markets," Annals of Economics and Finance, Society for AEF, vol. 2(2), pages 265-296, November.
- Grossman, Sanford J & Zhou, Zhongquan, 1996. " Equilibrium Analysis of Portfolio Insurance," Journal of Finance, American Finance Association, vol. 51(4), pages 1379-1403, September.
- repec:cup:macdyn:v:1:y:1997:i:1:p:169-205 is not listed on IDEAS
- Michael Gallmeyer & Burton Hollifield, "undated". "An Examination of Heterogeneous Beliefs with a Short Sale Constraint," GSIA Working Papers 2002-E2, Carnegie Mellon University, Tepper School of Business.
- Zapatero, Fernando, 1998. "Effects of financial innovations on market volatility when beliefs are heterogeneous," Journal of Economic Dynamics and Control, Elsevier, vol. 22(4), pages 597-626, April.
- David Cass & Alessandro Citanna, 1998. "Pareto improving financial innovation in incomplete markets," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 11(3), pages 467-494.
- David Cass & Alessandro Citanna, 1998. "Pareto Improving Financial Innovation in Incomplete Markets," Post-Print hal-00479286, HAL.
- Mas-Colell, Andreu, 1986. "The Price Equilibrium Existence Problem in Topological Vector Lattice s," Econometrica, Econometric Society, vol. 54(5), pages 1039-1053, September. Full references (including those not matched with items on IDEAS)