The risk neutral valuation paradox
This 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.
|Date of creation:||2011|
|Date of revision:|
|Contact details of provider:|| Postal: |
Web page: http://www.crenos.unica.it/
More information through EDIRC
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- Tirole, Jean, 1985. "Asset Bubbles and Overlapping Generations," Econometrica, Econometric Society, vol. 53(6), pages 1499-1528, November.
- Tirole, Jean, 1982. "On the Possibility of Speculation under Rational Expectations," Econometrica, Econometric Society, vol. 50(5), pages 1163-81, September.
- Schachermayer, W., 1992. "A Hilbert space proof of the fundamental theorem of asset pricing in finite discrete time," Insurance: Mathematics and Economics, Elsevier, vol. 11(4), pages 249-257, December.
- Harrison, J. Michael & Pliska, Stanley R., 1981. "Martingales and stochastic integrals in the theory of continuous trading," Stochastic Processes and their Applications, Elsevier, vol. 11(3), pages 215-260, August.
- Ernst Eberlein & Jean Jacod, 1997. "On the range of options prices (*)," Finance and Stochastics, Springer, vol. 1(2), pages 131-140.
- J. Bradford De Long & Andrei Shleifer & Lawrence H. Summers & Robert J. Waldmann, .
"Noise Trader Risk in Financial Markets,"
J. Bradford De Long's Working Papers
_124, University of California at Berkeley, Economics Department.
- Stephen A. O'Connell & Stephen P. Zeldes, .
"Rational Ponzi Games,"
Rodney L. White Center for Financial Research Working Papers
18-86, Wharton School Rodney L. White Center for Financial Research.
- Sonnenschein, Hugo, 1973. "Do Walras' identity and continuity characterize the class of community excess demand functions?," Journal of Economic Theory, Elsevier, vol. 6(4), pages 345-354, August.
- Kreps, David M., 1981. "Arbitrage and equilibrium in economies with infinitely many commodities," Journal of Mathematical Economics, Elsevier, vol. 8(1), pages 15-35, March.
- (**), Hui Wang & Jaksa Cvitanic & (*), Walter Schachermayer, 2001. "Utility maximization in incomplete markets with random endowment," Finance and Stochastics, Springer, vol. 5(2), pages 259-272.
- Harrison, J. Michael & Kreps, David M., 1979. "Martingales and arbitrage in multiperiod securities markets," Journal of Economic Theory, Elsevier, vol. 20(3), pages 381-408, June.
- Mantel, Rolf R., 1974. "On the characterization of aggregate excess demand," Journal of Economic Theory, Elsevier, vol. 7(3), pages 348-353, March.
- Martin Schweizer & Johannes Wissel, 2008. "Term Structures Of Implied Volatilities: Absence Of Arbitrage And Existence Results," Mathematical Finance, Wiley Blackwell, vol. 18(1), pages 77-114.
- Alexander Cox & David Hobson, 2005. "Local martingales, bubbles and option prices," Finance and Stochastics, Springer, vol. 9(4), pages 477-492, October.
- Debreu, Gerard, 1974. "Excess demand functions," Journal of Mathematical Economics, Elsevier, vol. 1(1), pages 15-21, March.
- Heath, David C & Jarrow, Robert A, 1987. " Arbitrage, Continuous Trading, and Margin Requirements," Journal of Finance, American Finance Association, vol. 42(5), pages 1129-42, December.
- Grossman, Sanford J & Stiglitz, Joseph E, 1980.
"On the Impossibility of Informationally Efficient Markets,"
American Economic Review,
American Economic Association, vol. 70(3), pages 393-408, June.
- Sanford J Grossman & Joseph E Stiglitz, 1997. "On the Impossibility of Informationally Efficient Markets," Levine's Working Paper Archive 1908, David K. Levine.
- Eli Ofek & Matthew Richardson, 2003. "DotCom Mania: The Rise and Fall of Internet Stock Prices," Journal of Finance, American Finance Association, vol. 58(3), pages 1113-1138, 06.
- Manuel S. Santos & Michael Woodford, 1993.
"Rational Asset Pricing Bubbles,"
9304, Centro de Investigacion Economica, ITAM.
- Sonnenschein, Hugo, 1972. "Market Excess Demand Functions," Econometrica, Econometric Society, vol. 40(3), pages 549-63, May.
- Kamara, Avraham & Miller, Thomas W., 1995. "Daily and Intradaily Tests of European Put-Call Parity," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 30(04), pages 519-539, December.
- Philip H. Dybvig & Chi-fu Huang, 1988.
"Nonnegative Wealth, Absence of Arbitrage, and Feasible Consumption Plans,"
Cowles Foundation Discussion Papers
860, Cowles Foundation for Research in Economics, Yale University.
- Philip H. Dybvig, Chi-fu Huang, 1988. "Nonnegative Wealth, Absence of Arbitrage, and Feasible Consumption Plans," Review of Financial Studies, Society for Financial Studies, vol. 1(4), pages 377-401.
- Peter Lakner, 1993. "Martingale Measures For A Class of Right-Continuous Processes," Mathematical Finance, Wiley Blackwell, vol. 3(1), pages 43-53.
- Cox, John C & Ross, Stephen A, 1976. "A Survey of Some New Results in Financial Option Pricing Theory," Journal of Finance, American Finance Association, vol. 31(2), pages 383-402, May.
- Black, Fischer & Scholes, Myron S, 1973. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 637-54, May-June.
- Duffie, Darrell & Huang, Chi-fu, 1986. "Multiperiod security markets with differential information : Martingales and resolution times," Journal of Mathematical Economics, Elsevier, vol. 15(3), pages 283-303, June.
- Freddy Delbaen, 1992. "Representing Martingale Measures When Asset Prices Are Continuous And Bounded," Mathematical Finance, Wiley Blackwell, vol. 2(2), pages 107-130.
- Camerer, Colin, 1989. " Bubbles and Fads in Asset Prices," Journal of Economic Surveys, Wiley Blackwell, vol. 3(1), pages 3-41.
When requesting a correction, please mention this item's handle: RePEc:cns:cnscwp:201112. See general information about how to correct material in RePEc.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Antonello Pau)
If references are entirely missing, you can add them using this form.