DERIVATIVE SECURITY MARKETS, MARKET MANIPULATION, AND OPTION PRICING THEORY

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 sto ck, money market account, and a derivative security, it is shown, by e xample, that the introduction of the derivative security generates mar ket manipulation trading strategies that would otherwise not exist. A sufficient condition is provided on the price process such that no add itional market manipulation trading strategies are introduced by a der ivative security. Options are priced under this condition, where it is shown that the standard binomial option model still applies but with random volatilities.