Effects of financial innovations on market volatility when beliefs are heterogeneous

We construct an intertemporal equilibrium with two agents with heterogeneous beliefs. Heterogeneity of beliefs induces volatility of the interest rate. We study the effect of financial innovation on interest rate volatility and conclude that, in a setting of asymmetric beliefs, introducing the asset that completes markets will (locally) increase the volatility of the endogenous interest rate process. We can design the "neutral" security so as to minimize the effects on volatility. Nevertheless, our model suggests that, overtime, introducing the new security will have a smoothing effect since beliefs will converge faster and uncertainty will be resolved quicker.

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