Inferring Financial Bubbles from Option Data

Robert Jarrow () and Simon Sai Man Kwok

No 2020-04, Working Papers from University of Sydney, School of Economics

Abstract: Financial bubbles arise when the underlying asset's market price deviates from its fundamen- tal value. Unlike other bubble tests that use time series data and assume a reduced-form price process, we infer the existence of bubbles nonparametrically using option price data. Under no-arbitrage and acknowledging data constraints, we can partially identify asset price bubbles using a cross section of European option prices. In the empirical analysis, we obtain interval estimates of price bubbles embedded in the S&P 500 Index. The estimated index bubbles are then used to construct profitable momentum trading strategies that consistently outperform a buy-and-hold trading strategy.

Keywords: asset price bubble; fundamental value; risk-neutral probability measure; state price distribution; partial identification; nonparametric estimation (search for similar items in EconPapers)
Date: 2020-04, Revised 2021-06
New Economics Papers: this item is included in nep-gen and nep-rmg
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Citations: View citations in EconPapers (8)

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Journal Article: Inferring financial bubbles from option data (2021)
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