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.
|Date of creation:||Jun 2006|
|Date of revision:|
|Contact details of provider:|| Postal: |
Phone: 44 - 20 - 7183 8801
Fax: 44 - 20 - 7183 8820
|Order Information:|| Email: |
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.:
- Michael Gallmeyer & Burton Hollifield, . "An Examination of Heterogeneous Beliefs with a Short Sale Constraint," GSIA Working Papers 2002-E2, Carnegie Mellon University, Tepper School of Business.
- Alessandro Citanna & Karl Schmedders, 2005. "Excess price volatility and financial innovation," Economic Theory, Springer, vol. 26(3), pages 559-587, October.
- 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.
- Hayne E. Leland., 1979.
"Who Should Buy Portfolio Insurance?,"
Research Program in Finance Working Papers
95, University of California at Berkeley.
- 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.
- 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 443-87, June.
- Gerard Gennotte and Hayne Leland., 1989.
"Market Liquidity, Hedging and Crashes,"
Research Program in Finance Working Papers
RPF-192, University of California at Berkeley.
- Mas-Colell, Andreu, 1986. "The Price Equilibrium Existence Problem in Topological Vector Lattice s," Econometrica, Econometric Society, vol. 54(5), pages 1039-53, September.
- David Cass & Alessandro Citanna, 1998. "Pareto improving financial innovation in incomplete markets," Economic Theory, Springer, vol. 11(3), pages 467-494.
- 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.
- 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 455-72, October.
- Jerome B. Detemple, 1990. "Financial Innovation, Values and Volatilities when Markets Are Incomplete*," The Geneva Risk and Insurance Review, Palgrave Macmillan, vol. 15(1), pages 47-53, March.
- Grossman, Sanford J & Zhou, Zhongquan, 1996. " Equilibrium Analysis of Portfolio Insurance," Journal of Finance, American Finance Association, vol. 51(4), pages 1379-1403, September.
- 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.
- 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.
- repec:cup:macdyn:v:1:y:1997:i:1:p:169-205 is not listed on IDEAS
- Huang, Jennifer & Wang, Jiang, 1997. "Market Structure, Security Prices, And Informational Efficiency," Macroeconomic Dynamics, Cambridge University Press, vol. 1(01), pages 169-205, January.
When requesting a correction, please mention this item's handle: RePEc:cpr:ceprdp:5726. See general information about how to correct material in RePEc.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: ()The email address of this maintainer does not seem to be valid anymore. Please ask to update the entry or send us the correct address
If references are entirely missing, you can add them using this form.