Journal of Risk

Risk.net

Asset price bubbles and risk management

Robert Jarrow

  • Asset price bubbles affect standard risk management methodologies and they need to be explicitly included.
  • Bubbles decrease a trader's optimal portfolio holdings in an asset.
  • Bubbles increase a financial institution's optimal level of equity capital.
  • Bubbles invalidate the risk-neutral valuation for derivatives and standard hedging techniques.

The purpose of this paper is to review the literature on asset price bubbles to study the impact that the existence of bubbles has on standard risk management methodologies. In the presence of asset price bubbles, a trader’s optimal portfolio holdings decrease and a financial institution’s optimal level of equity capital needs to be increased relative to a market without bubbles. Further, risk-neutral valuation for derivatives is often incorrect and the standard hedging techniques are suboptimal.

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