Financial Innovation and Asset Price Volatility
American Economic Review · 2012 · Volume 102 · Issue 3
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.
Keywords
Financial Markets and the Macroeconomy, Asset Pricing, Trading volume, Bond Interest Rates, General Aggregative Models: Neoclassical, Banks, Other Depository Institutions, Micro Finance Institutions, Mortgages
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