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The Effect of Introducing a Non-redundant Derivative on the Volatility of Stock-Market Returns

  • Bhamra, Harjoat Singh
  • Uppal, Raman

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.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 5726.

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Date of creation: Jun 2006
Date of revision:
Handle: RePEc:cpr:ceprdp:5726
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  1. 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.
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  8. 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.
  9. Huang, Jennifer & Wang, Jiang, 1997. "Market Structure, Security Prices, And Informational Efficiency," Macroeconomic Dynamics, Cambridge University Press, vol. 1(01), pages 169-205, January.
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