Efficiency and options on the market index

In a static exchange economy, when all the endowments are issued as securit ies on a stock exchange, Pareto optimal allocations may be reached by tradi ng options on the market index (see Breeden and Litzenberger (1978)). We ex tend this result when some of the risks cannot be exchanged on the market. Options on an appropriate index, which typically differs from the market in dex, depending on the correlation of the nontradable risks with the exchang ed securities, are still an appropriate tool to support a (constrained) eff icient equilibrium. This suggests that the recent development of derivative s based on interest rates may be an efficient way to reach a Pareto optimal allocation of risks.