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

30 Pages Posted: 16 Aug 2006

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)

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Date Written: June 2006

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

JEL Classification: G12, G13

Suggested Citation

Bhamra, Harjoat Singh and Uppal, Raman, The Effect of Introducing a Non-Redundant Derivative on the Volatility of Stock-Market Returns (June 2006). CEPR Discussion Paper No. 5726, Available at SSRN: https://ssrn.com/abstract=924405

Harjoat Singh Bhamra

Imperial College Business School ( email )

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Raman Uppal (Contact Author)

EDHEC Business School ( email )

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Centre for Economic Policy Research (CEPR)

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