More Hedging Instruments may destablize Markets

This paper formalizes the idea that more hedging instruments may destabilize markets when traders have heterogeneous expectations and adapt their behavior according to experience based reinforcement learning. In a simple asset pricing model with heterogeneous beliefs the introduction of additional Arrow securities may destabilize markets, and thus increase price volatility, and at the same time decrease average welfare. We also investigate whether a fully rational agent can employ additional hedging instruments to stabilize markets. It turns out that the answer depends on the composition of the population of non-rational traders and the information gathering costs for rationality. keywords: financial innovation, asset pricing, hedging, reinforcement learning, bifurcations Acknowledgments. Earlier versions of this paper have been presented at the SCE-conference on Computational Economics and Finance, Amsterdam, July 8-10, 2004, the workshop “Volatility of financial markets: theoretical models, forecasting and trading”, at the Lorentz Center Leiden, October 18-29, 2004, the workshop on “Complexity and Randomness in Economic Dynamical Systems”, Bielefeld, March 17-19, 2005, the ECB workshop on “Asset markets, expectations and learning”, November 6-7, 2006, the summer school on “Agent-based finance”, Trento, July 1-14, 2007, the “Complex markets” workshop, Warwick, April 4-5, 2008 and in various seminars. Stimulating discussions and helpful comments from Larry Blume, Wouter Den Haan, Doyne Farmer, Albert Marcet, Patrick Leoni, and other workshop and seminar participants are gratefully acknowledged. We are particularly grateful for the detailed comments by two anonymous referees and the Editor on an earlier draft, which have let to significant improvements. This research has been supported by the Netherlands Organization for Scientific Research (NWO), the NSF, the Vilas Trust and by a EU STREP-grant “Complex Markets”. a University of Wisconsin. Email: [email protected]. b University of Amsterdam, Email: [email protected] (Hommes) (corresponding author); [email protected] (Wagener).