DP5726 The Effect of Introducing a Non-redundant Derivative on the Volatility of Stock-Market Returns

Author(s): Harjoat Singh Bhamra, Raman Uppal
Publication Date: June 2006
Keyword(s): general equilibrium, options, risk-sharing, volatility
JEL(s): G12, G13
Programme Areas: Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=5726

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.