The risk neutral valuation paradox
AbstractThis paper highlights the role of risk neutral investors in generating endogenous bubbles in derivatives markets. We propose the following theorem. A market for derivatives, which has all the features of a perfect market except completeness and has some risk neutral investors, may exhibit almost surely 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. The theorem implies 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. In the paper, we demonstrate the theorem and we propose an application that solves the Grossman- Stiglitz paradox on the value of information.
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Bibliographic InfoPaper provided by Centre for North South Economic Research, University of Cagliari and Sassari, Sardinia in its series Working Paper CRENoS with number 201112.
Date of creation: 2011
Date of revision:
efficient market; fundamental theorem; bubble; risk neutral; martingale; derivatives;
Find related papers by JEL classification:
- G1 - Financial Economics - - General Financial Markets
- C73 - Mathematical and Quantitative Methods - - Game Theory and Bargaining Theory - - - Stochastic and Dynamic Games; Evolutionary Games
- C78 - Mathematical and Quantitative Methods - - Game Theory and Bargaining Theory - - - Bargaining Theory; Matching Theory
- G12 - Financial Economics - - General Financial Markets - - - Asset Pricing
- G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
This paper has been announced in the following NEP Reports:
- NEP-ALL-2011-08-02 (All new papers)
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