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American Economic Review: Vol. 102 No. 3 (May 2012)

AER Volume. 102, Issue 3 | Previous ArticleNext Article

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Financial Innovation and Asset Price Volatility

Article Citation

Kubler, Felix, and Karl Schmedders. 2012. "Financial Innovation and Asset Price Volatility." American Economic Review, 102(3): 147-51.

DOI: 10.1257/aer.102.3.147

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.

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Authors

Kubler, Felix (U Zurich and Swiss Finance Institute)
Schmedders, Karl (U Zurich and Swiss Finance Institute)

JEL Classifications

E44: Financial Markets and the Macroeconomy
G12: Asset Pricing; Trading volume; Bond Interest Rates
E13: General Aggregative Models: Neoclassical
G21: Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages