Detecting Money Market Bubbles

Jan Baldeaux, Katja Ignatieva and Eckhard Platen ()
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Katja Ignatieva: University of New South Wales Sydney

No 378, Research Paper Series from Quantitative Finance Research Centre, University of Technology, Sydney

Abstract: Using a range of stochastic volatility models well-known in the finance literature, we study the existence of money market bubbles in the US economy. Money market bubbles preclude the existence of a risk-neutral pricing measure. Understanding whether markets exhibit money market bubbles is crucial from the point of view of derivative pricing since their existence implies the existence of a self-financing trading strategy that replicates the savings account’s value at a fixed future date at a cheaper cost than the current value of the savings account. The benchmark approach is formulated under the real world probability measure and does not require the existence of a risk neutral probability measure. It hence emerges as the appropriate framework to study the potential existence of money market bubbles. Testing the existence of money market bubbles in the US economy we find that for all models the US market exhibits a money market bubble. This conclusion suggests that for derivative pricing and hedging care should be taken when making assumptions pertaining to the existence of a risk-neutral probability measure. Less expensive hedge portfolios may exist for a wide range of derivatives.

Keywords: Money market bubbles; strict local martingales; Markov chain Monte Carlo; stochastic volatility models; benchmark approach (search for similar items in EconPapers)
JEL-codes: C6 C63 G1 G13 (search for similar items in EconPapers)
Pages: 34 pages
Date: 2016-10-01
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (1)

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https://www.uts.edu.au/sites/default/files/QFR-rp378.pdf (application/pdf)

Related works:
Journal Article: Detecting money market bubbles (2018)
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