Working Paper: CEPR ID: DP5726
Authors: Harjoat Singh Bhamra; Raman Uppal
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; Risk-sharing; Volatility
JEL Codes: G12; G13
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| introduction of a nonredundant derivative (Y20) | stock market volatility (G17) |
| countercyclical discount rate (E52) | introduction of a nonredundant derivative increases stock market volatility (G19) |
| average prudence in the economy not too high (G19) | effect on volatility is magnified (C58) |
| improved risk sharing (G52) | volatility of stock returns exceeds that of an economy without such risk sharing (G17) |
| risk sharing alters distribution of wealth (D39) | affects discount rate (E43) |
| fundamental volatility + excess volatility (C58) | volatility of stock returns (G17) |