Skip Navigation


RFS Advance Access originally published online on December 11, 2007
Review of Financial Studies 2009 22(6):2303-2330; doi:10.1093/rfs/hhm076
This Article
Right arrow Full Text
Right arrow Full Text (PDF)
Right arrow All Versions of this Article:
22/6/2303    most recent
hhm076v1
Right arrow Alert me when this article is cited
Right arrow Alert me if a correction is posted
Services
Right arrow Email this article to a friend
Right arrow Similar articles in this journal
Right arrow Alert me to new issues of the journal
Right arrow Add to My Personal Archive
Right arrow Download to citation manager
Right arrowRequest Permissions
Google Scholar
Right arrow Articles by Bhamra, H. S.
Right arrow Articles by Uppal, R.
Social Bookmarking
Add to CiteULike   Add to Connotea   Add to Del.icio.us  
What's this?

© The Author 2007. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For permissions, please email: journals.permissions@oxfordjournals.org.

The Effect of Introducing a Non-Redundant Derivative on the Volatility of Stock-Market Returns When Agents Differ in Risk Aversion

Harjoat S. Bhamra
Sauder School of Business, University of British Columbia

Raman Uppal
London Business School and CEPR

Address correspondence to Harjoat S. Bhamra, Sauder School of Business at the University of British Columbia, 2053 Main Mall, Vancouver, BC, Canada V6T 1Z2; e-mail: harjoat.bhamra{at}sauder.ubc.ca.

JEL Classification: G12, D51, D52, D91


  Abstract

We study the effect of introducing a nonredundant 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. 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 nonredundant 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 also show that the volatility of the locally risk-free interest rate increases with the introduction of the derivative.

We gratefully acknowledge detailed suggestions from two anonymous referees. We are also grateful for comments from Suleyman Basak, Naresh Bhatia, Gianluca Cassese, Laurent Calvet, Joao Cocco, Francisco Gomes, Tim Johnson, Ken Judd, Alan Kraus, Leonid Kogan, Alexander Kurshev, Mordecai Kurz, Jun Liu, Michael Magill, Anthony Neuberger, Hernan Ortiz-Molina, Anna Pavlova, Marcel Rindisbacher, Jacob Sagi, Jan Werner, Hongjun Yan, and the participants at the meetings of the European Finance Association, the Arne Ryde Summer School in Economic Theory, the Stanford Institute for Theoretical Economics (SITE) Summer Workshop, the meetings of the WFA, the UBC Summer Conference, and seminar participants at LBS, UBC (Finance and Mathematics Departments), and USI Lugano. We wish to thank the Hedge Fund Centre at London Business School for financial support.


Add to CiteULike CiteULike   Add to Connotea Connotea   Add to Del.icio.us Del.icio.us    What's this?


This article has been cited by other articles:


Home page
 REV FINANC STUDHome page
W. Xiong and H. Yan
Heterogeneous Expectations and Bond Markets
Rev. Financ. Stud., November 15, 2009; (2009) hhp091v1.
[Abstract] [Full Text] [PDF]


Disclaimer: Please note that abstracts for content published before 1996 were created through digital scanning and may therefore not exactly replicate the text of the original print issues. All efforts have been made to ensure accuracy, but the Publisher will not be held responsible for any remaining inaccuracies. If you require any further clarification, please contact our Customer Services Department.