2 - Asset Price Bubbles (pt.1 - theory) Flashcards
What is the rational way of handling mispricing?
If you believe that an asset is overvalued, hence is mispriced, the rational thing to do is to attack the price by short-selling the asset.
What things can limit arbitrage and hence lead to bubbles?
- Short-sales constraints,
- Fundamental risk,
- Noise trader risk and myopia,
- Liquidation risk
What is the beauty contest analogy in relation to bubbles?
It is when the law of iterated expectations no longer holds so that public signals are systematically overweighted by each investor.
Describe how risk-shifting can create bubbles
If you assume that investors invest with borrowed money, so that we have an intermediary bank (agency problem!), then the investor will invest in riskier projects than what the bank prefer, since they receive the excess above debt payments, but lose nothing more than 100%. They bid the price of risky projects above the fundamentals. This is because risk is shifted over to the bank.
Can it make sense to hold an asset that you know is overpriced?
Yes! If you are able to see that the overpricing is a C-component (bubble) that is growing. If this C-component grows large enough to compensate you for the risk that it will burst sometime in the future (because yes it will, with prob 1-pi).
How much did the internet segment increase in returns during 1998-2000?
Ten-fold!!! A large increase. And then lost about 80% of its value during less than a year.
During Nasdaq bubble (internet), did the volume and price co-move?
Yes. Trading volume goes up and prices increase too.
M/B during the Nasdaq bubble?
It rose from a premium of 1-2 up til 7-fold difference during 2000.
What does the P/E ratios and years of superprofits imply for the Nasdaq bubble/internet firms?
That they have to make extreme superprofits for many years to justify the valuations at that time. Looking at the matrix table, it does not make sense, it is not realistic to make such profits for that period. The valuations must have been too high.
How much do pension funds invest in internet related to the market average?
Less! Around 3% weight in their portfolio whereas market is around 4.5%. Ofek & Rich. mean that this is a sign of a bubble since pension funds know what they do.
If you are pessimistic and want to short the asset, why is it so hard?
Because it is expensive to borrow the shares that you want to sell short. You need permission from the owner to lend shares –> hedge funds and pension funds do this but not retail investors –> and internet stocks were mainly held by retail investors. So it becomes structurally hard to short-sell.
What is the quiet period and what happens when it ends?
The Q period is the time when the owners cannot trade their shares. When this ends the number of shares increases and the trading volume goes up. This is followed by lower returns because it becomes easier to short-sell. So liquidity and volume affect returns.
What is the argument around uncertainty that makes it not a bubble? (Veronesi et al.)
It is: the volatility in returns on internet stock at this time was very high –> if uncertainty in future returns go up –> the expected returns go up (bc you only care about the right side of the distribution) –> so the prices also go up. Therefore it is not a bubble, but just higher expected returns due to higher volatility.
What happens to the matrix of M/B values when adding uncertainty?
Suddenly, for each equity premium level, the required excess ROE (profitability) decrease. For example, to see the actual 8.5 M/B, and for 2% premium, we can go from require 4,5% excess ROE down to 2,5% from the new internet firms, “thanks” to the volatility/uncertainty,
