Derivative Security Markets, Market Manipulation, and Option Pricing Theory

Robert Jarrow ()

Journal of Financial and Quantitative Analysis, 1994, vol. 29, issue 2, 241-261

Abstract: This paper studies a new theory for pricing options in a large trader economy. This theory necessitates studying the impact that derivative security markets have on market manipulation. In an economy with a stock, money market account, and a derivative security, it is shown, by example, that the introduction of the derivative security generates market manipulation trading strategies that would otherwise not exist. A sufficient condition is provided on the price process such that no additional market manipulation trading strategies are introduced by a derivative security. Options are priced under this condition, where it is shown that the standard binomial option model still applies but with random volatilities.

Date: 1994
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