Non-redundant derivatives in a dynamic general equilibrium economy

Bhamra, H S and Uppal, R (2003) Non-redundant derivatives in a dynamic general equilibrium economy. Working Paper. London Business School IFA Working Paper.

Abstract

In this article, we consider an experiment where a nonredundant derivative is introduced in an economy where agents are heterogenous with respect to their risk aversion. This experiment allows us to study the effect of introducing a nonredundant derivative on the prices of more primitive securities, such as a stock and bond. It also allows us to examine the valuation of this nonredundant derivative and the role it plays in an investor's dynamic portfolio strategy. We undertake this experiment by comparing to versions of a dynamic general equilibrium exchange economy where both the endowment and its growth rate are stochastic: in the first version, only a stock and a zerosupply instantaneously riskless bond are traded, while in the second version a derivative is also available. Our main contribution is to characterize in closed form (using asymptotic analysis) the equilibrium in these two versions of the economy, we find that the introduction of a derivative leads to an increase in the interest rate and the volatility of stock returns.