Endogenous Bubbles in Derivatives Markets: The Risk Neutral Valuation Paradox

TL;DR

This paper demonstrates that the presence of risk neutral investors in nearly complete derivatives markets can cause endogenous bubbles and extreme price movements, challenging traditional views of market efficiency.

Contribution

It introduces the risk neutral valuation paradox, showing how rational investors can generate endogenous bubbles in derivatives markets despite market efficiency assumptions.

Findings

Risk neutral investors can induce endogenous bubbles.

Extreme price movements can occur without external shocks.

Market prices may deviate from fundamental values more often.

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.