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Financial Innovation, Values and Volatilities when Markets Are Incomplete*

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Abstract

The traditional pricing methodology in finance values derivative securities as redundant assets that have no impact on equilibrium prices and allocations. This paper considers a model with incomplete markets in which the valuation of derivative securities cannot be treated independently from the valuation of the primary securities. The model constitutes a framework for the analysis of the consequences of financial innovation (creation of new contracts or modification of existing contracts). We provide a numerical counterexample to the popular belief that financial innovations that increase the volatilities of traded securities are “badâ€. In this example the introduction of an option increases the volatility of the rate of return on the underlying stock, yet the creation of this asset is unanimously supported by investors. The Geneva Papers on Risk and Insurance Theory (1990) 15, 47–53. doi:10.1007/BF01498459

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