Financial bubbles

Question 1

What are Financial bubbles?

Answer 1

Financial bubbles - prolonged periods of rising prices to levels vastly exceeding fundamentals (run-up phase). The rising prices are subsequently followed by sharp declines, sometimes even price crashes (crisis phase).

Prolonged periods, i.e., not the same as flash crashes, often with increased trading volume.

Question 2

Three factors shown to dampen laboratory bubbles with inexperienced subjects:

Answer 2

1) Low liquidity via low initial cash-to-asset ratio: Bubble more pronounced in cash rich setting (total cash amount equals twice the asset value) than in asset rich setting (total cash amount equals half the asset value).
2) Reducing supply of cash via deferred instead of immediate dividend payments.
3) Opening of the book with bid-ask orders by participants.

Implications:
“Bubbly” IPO market of the late 1990s: Small portion of the company sold to investors (“float”) vs. large appetite for these shares.
Quantitative easing by central banks can create bubbles.

Question 3

What is the effect of Lack of common knowledge of rationality?

Answer 3

Lack of common knowledge of rationality leads to speculation:
Rational speculators drive prices above FV believing to be able to resell at even higher price to irrational traders,
As end of horizon approaches incentives to speculate are reduced and prices fall.
Cheung et al (2012) show that inducing common knowledge of rationality (by training subjects) leads to fewer and smaller bubbles.
Lei et al (2001) restrict subjects to be either seller or buyer (speculation is impossible) - Bubbles still emerge!

Question 4

Could it be that subjects just cannot compute fundamental value or do not understand how it evolves over time, i.e., could subject confusion generate the bubble?

Answer 4

Kirchler et al. (2012) make fundamental value flat by adding a termination value and zero expected dividends,
Some experiments train subjects on how to calculate fundamental value (e.g., Lei and Vesely 2009).
Seems sufficient to get rid of bubbles.
Cheung et a. (2012) study what happens when subjects are trained on fundamental value but do not know that others have been similarly trained.
Bubbles re-emerge strongly,
It isn’t just confusion but also beliefs about others’ confusion that matters.

Question 5

How does experience matters?

Answer 5

Experience matters:
Participating for three times in the same experiment with the same group removes the bubble.
Possible explanations:
Experience and practice reduce subject confusion and remove the irrationality of market participants.
Market crash as vehicle whereby the newly established rationality of market participants becomes common knowledge.

Question 6

Hussam, Porter and Smith (2008) what are the conclusions of?

Answer 6

1) Experience alone is not a sufficient condition to ensure the elimination of price bubbles!
2) When important elements in the underlying market environment change for experienced subjects, a bubble can reignite.
3) An environment with high liquidity and high-dividend spread can sustain a bubble in amplitude despite experience.
4) These conditions can exist in reality: Stock market booms driven by waves of new technology:
- New sources of unpredictable yield uncertainty (high dividend spread). - New liquidity attracted to equity investment.
- DotCom bubble

Question 7

Who bought technology stocks in the build-up of the bubble?

Answer 7

Net active buying: During the run-up, institutions account for 63.6% of purchases.

Question 8

Trading patterns around the market peak: Who sold stock at the peak?

Answer 8

During the run-up, IPOs and insider sales make up for 33.4% and 17.0% of increase in supply.

Question 9

Are institutional investors trading in the direction of future fundamentals?

Answer 9

• Sophisticated investors do not always move against mispricing (central element of market efficiency).
• Sophisticated investors, like hedge funds, actively purchased technology stocks during the run-up, but reversed course in March 2000, driving the collapse.
• Individual investors actively bought during both the run-up and particularly the collapse of technology stocks.
• Evidence consistent with speculation motives fueling the bubble until coordinated selling effort occurs (Abreu and Brunnermeier 2003).

Question 10

What were the impact of speculation and frictions in Dotcom bubble?

Answer 10

Frictions:
Limits to arbitrage: Fundamental/noise trader risk, transaction costs, … Arbitrageurs cannot eliminate bubble, prices driven by sentiment traders. Ofek and Richardson (2003):
More retail investors in internet than in non-internet stocks.
Substantially higher short sales restrictions for internet stocks in run-up phase. Increasing share supply via IPO lockup expirations contributed to bubble burst.
Rational speculators:
Rational speculators drive the bubble expecting that other (e.g., momentum) traders will purchase securities at even higher prices.
Arbitrageurs ride the bubble understanding the overvaluation.
Capital constraints: only coordinated selling of arbitrageurs eliminates bubble. Griffin, Harris, Shu and Topaloglu (2011).

Question 11

Full awareness hypothesis (housing bubble)

Answer 11

Securitization agents exhibited more awareness of a housing bubble relative to equity analysts and lawyers in four possible forms:

1. Market timing form - securitization agents were more likely to divest homes and downsize homes in 2004–2006.
2. Cautious form - securitization agents were less likely to acquire second homes or move into more expensive homes in 2004–2006.
3. Performance - securitization agents had better housing portfolio performance after controlling for their initial holdings of homes at the beginning of 2000.
4. Conservative consumption - relative to their current income, any purchases made by securitization agents during the boom were more conservative.