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Detecting Money Market Bubbles

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Using a range of stochastic volatility models well-known in the finance literature, we study the existence of money market bubbles in the US economy. Money market bubbles preclude the existence of a risk-neutral pricing measure. Understanding whether markets exhibit money market bubbles is crucial from the point of view of derivative pricing since their existence implies the existence of a self-financing trading strategy that replicates the savings account’s value at a fixed future date at a cheaper cost than the current value of the savings account. The benchmark approach is formulated under the real world probability measure and does not require the existence of a risk neutral probability measure. It hence emerges as the appropriate framework to study the potential existence of money market bubbles. Testing the existence of money market bubbles in the US economy we find that for all models the US market exhibits a money market bubble. This conclusion suggests that for derivative pricing and hedging care should be taken when making assumptions pertaining to the existence of a risk-neutral probability measure. Less expensive hedge portfolios may exist for a wide range of derivatives.

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  • Jan Baldeaux & Katja Ignatieva & Eckhard Platen, 2016. "Detecting Money Market Bubbles," Research Paper Series 378, Quantitative Finance Research Centre, University of Technology, Sydney.
    • Handle: RePEc:uts:rpaper:378
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    Cited by:

    1. Yang, Bingduo & Long, Wei & Yang, Zihui, 2022. "Testing predictability of stock returns under possible bubbles," Journal of Empirical Finance, Elsevier, vol. 68(C), pages 246-260.
    2. Kevin Fergusson & Eckhard Platen, 2017. "Less-Expensive Valuation of Long Term Annuities Linked to Mortality, Cash and Equity," Papers 1711.02808, arXiv.org.
    3. Eckhard Platen & Renata Rendek, 2019. "Dynamics of a Well-Diversified Equity Index," Research Paper Series 398, Quantitative Finance Research Centre, University of Technology, Sydney.
    4. Márcio P. Laurini & Pedro Chaim, 2021. "Brazilian stock market bubble in the 2010s," SN Business & Economics, Springer, vol. 1(1), pages 1-19, January.
    5. Chaim, Pedro & Laurini, Márcio P., 2019. "Is Bitcoin a bubble?," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 517(C), pages 222-232.
    6. Pedro L. P. Chaim & Márcio P. Laurini, 2019. "Foreign Exchange Expectation Errors and Filtration Enlargements," Stats, MDPI, vol. 2(2), pages 1-16, April.

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    More about this item

    Keywords

    Money market bubbles; strict local martingales; Markov chain Monte Carlo; stochastic volatility models; benchmark approach;
    All these keywords.

    JEL classification:

    • C6 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling
    • C63 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Computational Techniques
    • G1 - Financial Economics - - General Financial Markets
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing

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