Excess price volatility and financial innovation (Q2569180)

This paper assumes discrete time dynamic trading of the asset in a finite economy. It uses the frame work of Cass and Citanna (1998) and extends it to a multi-period trading. There are made several conclusions. In an economy with no aggregate risk, namely if the asset price shows zero volatility with a complete market, it is proved that financial innovation reducing the market incompleteness must reduce the price volatility. In an economy with aggregate risk, financial innovation reducing the price volatility does not necessarily reduce the market incompleteness. It also shows how to design volatility-reducing assets. The authors discuss two cases: When the designed new asset can be retraded, a comparison between incomplete and complete markets is possible. In the case of impossibility of retrading, the condition is weaker.