Asset bubbles

Question 1

Asset bubble defenition

Answer 1

Asset price above fundamental value - diffcult to measure the value

Question 2

Ex ante approach identifying bubble

Answer 2

Historical comparioson to estimate the fundamental value
vb. historical ratio of share prices to revenues

Problem: This time is different & no information about new asset classes

Question 3

Ex post approach indentifying bubble

Answer 3

Identify by large fall in price (after burst of the bubble)
vb. historical examples today

Problem: no use for preventive policy & risk of misidentification: mix project risk with asset bubble

Question 4

Key elements Mississippi bubble

Answer 4

A growing company emitting shares to finance their operations. Taking over large government debt and buying** influence** and privileges.

Each new share issuance took place at a higher price, largest losses to last buyers

Question 5

How do bubbles start

Answer 5

After a financial/credit** liberalization** and/ord expansive monetary policy

Question 6

How do bubbles burst

Answer 6

With realization of ** low returns ** or monetary/credit policy tightening

Question 7

Allen & Gale modeling bubble

Answer 7

Safe en risky asset (felxible - fixed supply):

Safe asset: return on date 2 & sells at date 1 to price Ps
Risky asset: high and low return: expected return

Question 8

Fundamental price in asset bubbles
Investors are: risk neutral, wealth 1, cannot borrow

Answer 8

The expected return: (Rs/Ps) = E(R)/Pf

Question 9

Fundamental price of risky asset:

Answer 9

Pf = Ps x (E(R) / Rs)
this is the NPV of the risky asset discounted with the risk free interest rate

Price above: burst bubble

Question 10

When will bubble burst?

Answer 10

If the price is above the fundamental price

Question 11

Fundamental price when investors have no wealth? They borrow at at rate RI (2 other assumptions)

Answer 11

Limited liability: at date 2 repay 1.33 (RI) or lender can claim the whole return
Lender cannot observe how loans are invested

Question 12

How to find the equilibrium price in intermediate case?

Answer 12

Return on safe asset: (Rs/Ps) - RI

Return on risky asset: Expected value of max en min (R/Pf - RI, 0)

Expected returns have to be equal: Pb

Question 13

No monitoring of loans lead to:

Answer 13

Risk shifting, the investor shifts the potential losses to the lender

Pb

Question 14

Risk shifting:

Answer 14

Generates extra profits for the** investor**

The greater the risk, the **higher the price of the asset **

proof: Rh 6 prob 0,25
Rl 1 prob 0,75
R I : 1,33

vs. Rh 9 prob 0,25 and R l 0 prob 0,75

Change the risk and probability, find Pb

Question 15

Risk shifting in reality

Answer 15

Often in high tech stocks

**Innovation **creates uncertain payoff –> more risk-shifting opportunities

Question 16

Asymmetric information among investors

Answer 16

Assume: unknown future return but expert has knowledge

Less informed investors use market price to deduct information possessed by others

**High prices **create expectations of high future returns –> incentive to invest + push prices up

Early investors enjoy high gains, late investors face big losses

Question 17

Tulpmania in Netherlands

Answer 17

It’s a good future trade

Question 18

John Law and the missipi bubble

Answer 18

In unemployed resources, emission of paper currency can stimulate the economy and create demand for currency, without creating pressure on the price.

Law controled everything: every expansion is financed with further share issuance (each at higher price) –> increasy money supply –> inflation

Question 19

The south sea bubble

Answer 19

Take over of public debt through share issuance

Question 20

The dot com bubble

Answer 20

Quick expansion internet, high stock increase

Question 21

Limited liability

Answer 21

At date 2 either repay the full RI or lender claims whole return (get 0)

Question 22

When return of risky asset > return safe asset

Answer 22

Risky asset dominates

Question 23

Easy credit with low monitoring creates perverse incentives

Answer 23

Risky projects are** priced** above fundamental price

More risk –> higher price

Limited info –> amplify the bubble

Question 24

Current environment

Answer 24

Record low intrest rate
Improves micro and macroprudential policies might limit risk-taking