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Derivative Security Markets, Market Manipulation, and Option Pricing Theory

Published online by Cambridge University Press:  06 April 2009

Robert A. Jarrow
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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.

Type
Research Article
Information
Journal of Financial and Quantitative Analysis , Volume 29 , Issue 2 , June 1994 , pp. 241 - 261
Copyright
Copyright © School of Business Administration, University of Washington 1994

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