Inferring financial bubbles from option data

Summary Financial bubbles arise when the underlying asset's market price deviates from its fundamental 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‐arbitr...

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Bibliographic Details
Published inJournal of applied econometrics (Chichester, England) Vol. 36; no. 7; pp. 1013 - 1046
Main Authors Jarrow, Robert A., Kwok, Simon S.
Format Journal Article
LanguageEnglish
Published Chichester Wiley Periodicals Inc 01.11.2021
Subjects
asset price bubble
Assets
Econometrics
Empirical analysis
fundamental value
nonparametric estimation
Nonparametric statistics
partial identi.cation
Prices
risk‐neutral probability measure
Securities prices
state price distribution
Time series
Trading
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Summary:Summary Financial bubbles arise when the underlying asset's market price deviates from its fundamental 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.
ISSN:0883-7252
1099-1255
DOI:10.1002/jae.2862