Endogenous Bubbles in Derivatives Markets: The Risk Neutral Valuation Paradox
Abstract
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.
Keywords
Cite
@article{arxiv.1106.5274,
title = {Endogenous Bubbles in Derivatives Markets: The Risk Neutral Valuation Paradox},
author = {Alessandro Fiori Maccioni},
journal= {arXiv preprint arXiv:1106.5274},
year = {2011}
}
Comments
21 pages. The second version presents the following upgrades: improved precision in the definition of agents and their behaviour; simplification in the notation of the probability measure; simplification in section 4.1; addition of caveats in the conclusions. The results of the second version remain unchanged