Investor Irrationality and the Nasdaq Bubble

Abstract:     
We exploit the information in the options market to study the risk and risk premium variations around the Nasdaq bubble period. In particular, we investigate whether the dramatic rise and fall of the Nasdaq can be justified by changes in return risk, or there were corresponding unusual shifts in how investors price risks. We specify a model that accommodates fluctuations in both risk levels and market prices of different sources of risks, and we estimate the model using time-series returns and option prices on the Nasdaq 100 index. Our analysis reveals three key pieces of evidence that foretell the arrival and burst of a bubble. First, during the Nasdaq bubble period, return volatility increased together with the rising index level, even though the two tend to move in opposite directions in general. Second, while the market price of volatility risk is strongly negative historically as investors dislike high volatility levels and volatility risk, the market price of volatility risk declined in absolute magnitude and approached zero at the end of 1999. In contrast to the average risk premium at normal market conditions, aversion to volatility risk completely disappeared during the height of the bubble period. Third, the options market showed an increasing market price of downside jump risk that peaked three month prior to the bursting of the bubble, highlighting the increasing demand for hedging against the potential crash of the Nasdaq market valuation. On the other hand, the market price of the downside jump risk dropped suddenly three months prior to the burst, pointing to capital flight from the Nasdaq market and the unwinding of the associated option hedging positions. Our approach suggests that having options on the bubble asset provides a window into investor behavior unavailable from earlier bubbles.

Keywords: Nasdaq bubble, risks, risk premiums, market prices of risks, variations in risk preferences, diffusion risk, volatility risk, downside jump risk, options

JEL Classifications: G10, G12, G13, C51

Working Paper Series