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Do hedging instruments stabilize markets?

Author

Listed:
  • Florian Wagener
  • William Brock
  • Cars Hommes

Abstract

There is a general argument saying that adding derivative securities (options) to a financial market makes the market more efficient, and has therefore a stabilising effect. We investigate this claim by adding Arrow securities on future states of the world in the asset pricing model with heterogeneous beliefs of Brock and Hommes (1998). We also extend the model to an overlapping generations general equilibrium setting with consumption. The fitness measure underlying the evolutionary switching of investment strategies is realized utility averaged over the different states of the economy. Agents differ in their beliefs about the future market price of the risky asset. If they do not pay much attention to how well other strategies perform, the fundamental equilibrium price is stable; if however agents are sensitive to differences in fitness stability is lost. We investigate whether the introduction of Arrow securities stabilises or destabilises the market, that is, whether the fundamental steady state loses stability sooner or later.

Suggested Citation

  • Florian Wagener & William Brock & Cars Hommes, 2004. "Do hedging instruments stabilize markets?," Computing in Economics and Finance 2004 94, Society for Computational Economics.
  • Handle: RePEc:sce:scecf4:94
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    References listed on IDEAS

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    1. Finn E. Kydland & Edward C. Prescott, 1996. "The Computational Experiment: An Econometric Tool," Journal of Economic Perspectives, American Economic Association, vol. 10(1), pages 69-85, Winter.
    2. Johann Peter Murmann & Thomas Brenner, 2003. "The Use of Simulations in Developing Robust Knowledge about Causal Processes: Methodological Considerations and an Application to Industrial Evolution," Computing in Economics and Finance 2003 66, Society for Computational Economics.
    3. Machlup, Fritz, 1978. "Methodology of Economics and Other Social Sciences," Elsevier Monographs, Elsevier, edition 1, number 9780124645509 edited by Shell, Karl.
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    6. Dominique Foray & Robin Cowan, 2002. "Evolutionary economics and the counterfactual threat: on the nature and role of counterfactual history as an empirical tool in economics," Journal of Evolutionary Economics, Springer, vol. 12(5), pages 539-562.
    7. Malerba, Franco, et al, 1999. "'History-Friendly' Models of Industry Evolution: The Computer Industry," Industrial and Corporate Change, Oxford University Press, vol. 8(1), pages 3-40, March.
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    More about this item

    Keywords

    heterogeneous agents; evolutionary dynamics; hedging instruments;

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles

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