Local martingales, bubbles and option prices (Q2488491)

The authors study the option pricing in markets with bubbles. A bubble is defined to be a price process which, when discounted, is a local martingale under the risk-neutral measure but not a martingale. The existence of an equivalent local martingale measure is assumed. It is supposed that under the pricing measure the asset is a strict local martingale. This is a sense in which the price process satisfies a bubble -- the current price exceeds the expected discounted future price (under the risk-neutral measure). The authors are interested in consequences of assuming that the discounted trading price of an asset is not a martingale. Some examples of bubble are given. One of them has a direct interpretation in terms of a bubble via a feedback mechanism. It is proved that many standard results fail to hold when there is a bubble, for example, put-call parity. One of the key ideas is the notion of an admissible strategy and the option value depends critically on this definition. The ways are discussed in which the price of the derivative depends on rules for the option trading imposed by internal or external regulation.