Excess price volatility and financial innovation

Alessandro Citanna () and Karl Schmedders

Economic Theory, 2005, vol. 26, issue 3, 559-587

Abstract: In a three-period finite exchange economy with incomplete financial markets and retrading, we study the effects of the degree of incompleteness and of changes in the financial structure on asset price volatility. In what are essentially no aggregate risk economies, asset price volatility is a sunspot-like phenomenon. If markets are completed by financial innovation, asset price volatility reduction is generic. With aggregate risk, changes in the financial structure affect asset price volatility through a pecuniary externality. Financial innovation which decreases equilibrium price volatility can be crafted under conditions of sufficient market incompleteness. Numerical examples illustrate the role of risk aversion for volatility changes and show that, with or without aggregate risk, reducing the degree of incompleteness per se is not necessarily associated with a volatility reduction. Copyright Springer-Verlag Berlin/Heidelberg 2005

Keywords: Incomplete markets; Financial innovation; Volatility. (search for similar items in EconPapers)
Date: 2005
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DOI: 10.1007/s00199-004-0532-2

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