Information and Derivatives

18 January 2018
Jerome Detemple

We study a dynamic multi-asset economy with private information, a stock and a derivative. There are informed and uninformed investors as well as bounded rational investors trading on noise. The noisy rational expectations equilibrium is obtained in closed form. The equilibrium stock price follows a non-Markovian process, is positive and has stochastic volatility. The derivative cannot be replicated, except at rare endogenous times. At any point in time, the derivative price adds information relative to the stock price, but the pair of prices is less informative than volatility, the residual demand or the history of prices. The rank of the asset span drops at endogenous times causing turbulent trading activity. The effects of financial innovation are discussed. The equilibrium is fully revealing if the derivative is not traded: financial innovation destroys information.

  • Mathematical and Computational Finance Seminar