The Effect of Introducing a Non-Redundant Derivative on the Volatility of Stock-Market Returns When Agents Differ in Risk Aversion

Posted: 1 Jun 2009

See all articles by Harjoat Singh Bhamra

Harjoat Singh Bhamra

Imperial College Business School

Raman Uppal

EDHEC Business School; Centre for Economic Policy Research (CEPR)

Date Written: June 2009

Abstract

We study the effect of introducing a nonredundant derivative on the volatilities of the stock market return and the locally risk-free interest rate. Our analysis uses a standard, frictionless, full-information, dynamic, continuous-time, general-equilibrium, Lucas endowment economy in which there are two classes of agents who have time-additive power utility functions and differ only in their risk aversion. Our main result is to show analytically that if the intensity of the precautionary demand for savings is not too high, then the introduction of a nonredundant derivative increases the volatility of stock market returns. Furthermore, in the economy with the derivative, the volatility of stock market returns can be substantially greater than that of aggregate dividend growth (fundamental volatility). We also show that the volatility of the locally risk-free interest rate increases with the introduction of the derivative.

Keywords: G12, D51, D52, D91

Suggested Citation

Bhamra, Harjoat Singh and Uppal, Raman, The Effect of Introducing a Non-Redundant Derivative on the Volatility of Stock-Market Returns When Agents Differ in Risk Aversion (June 2009). The Review of Financial Studies, Vol. 22, Issue 6, pp. 2303-2330, 2009, Available at SSRN: https://ssrn.com/abstract=1408426 or http://dx.doi.org/hhm076

Harjoat Singh Bhamra (Contact Author)

Imperial College Business School ( email )

Tanaka Building
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United Kingdom

HOME PAGE: http://www.harjoatbhamra.com

Raman Uppal

EDHEC Business School ( email )

58 rue du Port
Lille, 59046
France

Centre for Economic Policy Research (CEPR)

90-98 Goswell Road
London, EC1V 7RR
United Kingdom

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