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

40 Pages Posted: 15 Mar 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)

Multiple version iconThere are 2 versions of this paper

Date Written: March 14, 2006

Abstract

We study the effect of introducing a non-redundant 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. 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 non-redundant zero-net-supply derivative. 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 non-redundant 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 show also that the volatility of the locally risk-free interest rate increases with the introduction of the derivative.

Keywords: Excess volatility, general equilibrium, heterogeneous agents, prudence

JEL Classification: 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 (March 14, 2006). Sauder School of Business Working Paper; AFA 2007 Chicago Meetings Paper. Available at SSRN: https://ssrn.com/abstract=891002 or http://dx.doi.org/10.2139/ssrn.891002

Harjoat Singh Bhamra

Imperial College Business School ( email )

Tanaka Building
Exhibition Rd
London, SW7 2AZ
United Kingdom

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

Raman Uppal (Contact Author)

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

Register to save articles to
your library

Register

Paper statistics

Downloads
319
Abstract Views
1,943
rank
91,542
PlumX Metrics