Pecuniary Externalities of Futures Trading and Constrained Suboptimality

Abstract:     
This study investigates the constrained suboptimality of a futures market equilibrium in incomplete markets. It explains the constrained suboptimality in terms of the pecuniary externalities that futures trading may cause by affecting spot relative prices. It presents the decomposition of a pecuniary externality into hedging and speculative factors and, by these factors, characterizes the constrained suboptimality. This characterization gives interpretable sufficient conditions which can exclude, from a futures market equilibrium, Hart's pathology that the opening of a new market makes every agent worse off or, equivalently, that the closing of an existing market makes every agent better off.

JEL Classification: G13

Accepted Paper Series