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PRICE UNCERTAINTY AND DERIVATIVE SECURITIES

By Geoffrey Heal, G. Chichilnisky and J. Dutta

Abstract

We consider trade in contracts which provide insurance against price uncertainty. This uncertainty results from the presence of multiple equilibria. Rational traders thus have an intrinsic inability to predict the functioning of the economic system. We assume that they know, and agree on, the objective probabilities with which each equilibrium price vector realizes, and can trade in commodities contingent on the equilibrium. With an extension of the market structure in Arrow [1], these markets allow traders to insure fully against the risk stemming from uncertainty about prices. However, they introduce further uncertainty because there may be several equilibrium prices for price-contingent commodities. The introduction of higher-order derivative products removes this uncertainty, but in turn introduces uncertainty about the prices of these products. This process converges in a finite number of steps to a unique fully-insured Pareto efficient allocation. The introduction of derivative price-contingent securities removes all uncertainty associated with inability to predict equilibrium prices. We thus provide a mechanism for resolvin

Topics: endogenous uncertainty, price uncertainty, derivative securities, index securities, multiple equilibria
Year: 1995
OAI identifier: oai:CiteSeerX.psu:10.1.1.195.9447
Provided by: CiteSeerX
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