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Macroeconomic Dynamics, 1, 1997, 169–205. Printed in the United States of America.



Sloan School of Management, Massachusetts Institute of Technology


Sloan School of Management, Massachusetts Institute of Technology and National Bureau of Economic Research

We consider an economy with an incomplete securities market and heterogeneously informed investors. Each investor trades in the market to hedge the risk to his endowment and to speculate on future security payoffs using his private information. We examine the efficiency of the securities market in allocating risk and transmitting information under different market structures, as defined by the set of securities traded in the market. We show that the introduction of derivative securities can decrease the market’s efficiency in revealing information on security payoffs, and increase the equity premium and price volatility in the market. Keywords: Securities Market, Market Structure, Security Prices, Communication Efficiency

1. INTRODUCTION A securities market performs two important functions: allocating risk and communicating information among investors [see, e.g., Hayek (1945), Debreu (1959), and Arrow (1964)]. How efficiently the market performs these two functions crucially depends on the market structure, as defined by the set of securities traded in the market. Over time, the structure of the securities market changes as new securities are introduced. In the literature, the impact of these changes on the market’s informational efficiency has been studied separately from the impact on its allocational efficiency. For example, in analyzing the informational role of derivative trading, the allocational trade in the market often is specified exogenously (as “noise”) [see, e.g., Grossman (1977)]. As pointed out by Grossman (1995), the informational role and the allocational role of the securities market are fundamentally...