Excess price volatility and financial innovation

Alessandro Citanna, Karl Schmedders

Research output: Contribution to journalArticlepeer-review

Abstract

In a three-period finite exchange economy with incomplete financial markets and retrading, we study the effects of the degree of incompleteness and of changes in the financial structure on asset price volatility. In what are essentially no aggregate risk economies, asset price volatility is a sunspot-like phenomenon. If markets are completed by financial innovation, asset price volatility reduction is generic. With aggregate risk, changes in the financial structure affect asset price volatility through a pecuniary externality. Financial innovation which decreases equilibrium price volatility can be crafted under conditions of sufficient market incompleteness. Numerical examples illustrate the role of risk aversion for volatility changes and show that, with or without aggregate risk, reducing the degree of incompleteness per se is not necessarily associated with a volatility reduction.

Original languageEnglish (US)
Pages (from-to)559-587
Number of pages29
JournalEconomic Theory
Volume26
Issue number3
DOIs
StatePublished - 2005

Keywords

  • Financial innovation
  • Incomplete markets
  • Volatility

ASJC Scopus subject areas

  • Economics and Econometrics

Fingerprint Dive into the research topics of 'Excess price volatility and financial innovation'. Together they form a unique fingerprint.

Cite this