Asset bubbles Flashcards
Asset bubble defenition
Asset price above fundamental value - diffcult to measure the value
Ex ante approach identifying bubble
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
Ex post approach indentifying bubble
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
Key elements Mississippi bubble
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
How do bubbles start
After a financial/credit** liberalization** and/ord expansive monetary policy
How do bubbles burst
With realization of ** low returns ** or monetary/credit policy tightening
Allen & Gale modeling bubble
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
Fundamental price in asset bubbles
Investors are: risk neutral, wealth 1, cannot borrow
The expected return: (Rs/Ps) = E(R)/Pf
Fundamental price of risky asset:
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
When will bubble burst?
If the price is above the fundamental price
Fundamental price when investors have no wealth? They borrow at at rate RI (2 other assumptions)
Limited liability: at date 2 repay 1.33 (RI) or lender can claim the whole return
Lender cannot observe how loans are invested
How to find the equilibrium price in intermediate case?
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
No monitoring of loans lead to:
Risk shifting, the investor shifts the potential losses to the lender
Pb
Risk shifting:
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
Risk shifting in reality
Often in high tech stocks
**Innovation **creates uncertain payoff –> more risk-shifting opportunities
Asymmetric information among investors
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
Tulpmania in Netherlands
It’s a good future trade
John Law and the missipi bubble
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
The south sea bubble
Take over of public debt through share issuance
The dot com bubble
Quick expansion internet, high stock increase
Limited liability
At date 2 either repay the full RI or lender claims whole return (get 0)
When return of risky asset > return safe asset
Risky asset dominates
Easy credit with low monitoring creates perverse incentives
Risky projects are** priced** above fundamental price
More risk –> higher price
Limited info –> amplify the bubble
Current environment
Record low intrest rate
Improves micro and macroprudential policies might limit risk-taking
