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

Raman Uppal and Harjoat Bhamra

No 5726, CEPR Discussion Papers from C.E.P.R. Discussion Papers

Abstract: 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.

Keywords: General equilibrium; Options; Volatility; Risk-sharing (search for similar items in EconPapers)
JEL-codes: G12 G13 (search for similar items in EconPapers)
Date: 2006-06
New Economics Papers: this item is included in nep-dge, nep-fin and nep-upt
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (7)

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