The Behavior of Risk and Market Prices of Risk Over the Nasdaq Bubble Period

We exploit the information in the options market to study the variations of return risk and market prices of different sources of risk during the rise and fall of the Nasdaq market. We specify a model that accommodates fluctuations in both risk levels and market prices of different sources of risk, and we estimate the model using the time‐series returns and option prices on the Nasdaq 100 tracking stock. Our analysis reveals three key variations during the period from March 1999 to March 2001. First, return volatility increased together with the rising Nasdaq index level, even though the two tend to move in opposite directions. Second, although the market price of diffusion return risk averages around 1.82 over the whole sample, the estimates reached negative territory at the end of 1999. The estimates reverted back to highly positive values after the collapse of the Nasdaq market. Third, the market price of jump risk increased with the rising Nasdaq valuation, and this increase in market price coincided with an increased imbalance in open interest between put and call options.