Endogenous Bubbles in Derivatives Markets: The Risk Neutral Valuation Paradox

Details Endogenous Bubbles in Derivatives Markets: The Risk Neutral Valuation Paradox Endogenous Bubbles in Derivatives Markets: The Risk Neutral Valuation Paradox

2011-06-26

arxiv.org/abs/1106.5274v2

Economy

Quantitative Finance

Trading and Market Microstructure

21 pages. The second version presents the following upgrades: improved precision in the definition of agents and their behavio

Scientific paper

This paper highlights the role of risk neutral investors in generating endogenous bubbles in derivatives markets. We find that a market for derivatives, which has all the features of a perfect market except completeness and has some risk neutral investors, can exhibit extreme price movements which represent a violation to the Gaussian random walk hypothesis. This can be viewed as a paradox because it contradicts wide-held conjectures about prices in informationally efficient markets with rational investors. Our findings imply that prices are not always good approximations of the fundamental values of derivatives, and that extreme price movements like price peaks or crashes may have endogenous origin and happen with a higher-than-normal frequency.

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