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Financial Innovation and Asset Price Volatility

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Abstract:

We compare asset prices in an overlapping generations model for incomplete and complete markets. Individuals within a generational cohort have heterogeneous beliefs about future states of the economy and thus would like to make bets against each other. In the incomplete-markets economy, agents cannot make such bets. Asset price volatility is very small. The situation changes dramatically when markets are completed through financial innovations as the set of available securities now allows agents with different beliefs to place bets against each other. Wealth shifts across agents and generations. Such changes in the wealth distribution lead to substantial asset price volatility.

Document Type: Research Article

DOI: https://doi.org/10.1257/aer.102.3.147

Publication date: 2012-05-01

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