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.