Do hedging instruments stabilize markets?
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.
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