More Hedging Instruments May Destabilize Markets
William A. Brock
University of Wisconsin, Madison - Department of Economics ; University of Missouri at Columbia - Department of Economics
C. H. Hommes
University of Amsterdam; CeNDEF; Tinbergen Institute
Florian O. Wagener
University of Amsterdam - Center for Nonlinear Dynamics in Economics and Finance (CeNDEF) - Department of Quantitative Economics; Tinbergen Institute
TI Discussion Paper No. 06-080/1
This paper formalizes the idea that more hedging instruments may destabilize markets when traders are heterogeneous and adapt their behavior according to experience based reinforcement learning. We investigate three different economic settings, a simple mean-variance asset pricing model, a general equilibrium two-period overlapping generations model with heterogeneous expectations and a noisy rational expectations asset pricing model with heterogeneous information signals. In each setting the introduction of additional Arrow securities can destabilize the market, causing a bifurcation of the steady state to multiple steady states, periodic orbits or even chaotic fluctuations.
Number of Pages in PDF File: 34
Keywords: Asset pricing, hedging, reinforcement learning, nonlinear dynamics, bifurcations
JEL Classification: D52, D53, D83, D84, G32
Date posted: September 28, 2006 ; Last revised: May 27, 2008
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