Lecture 7-Bubbles

Question 1

What is sentiment?

Answer 1

-Periods of high optimism (positive sentiment), stock prices are high and won offer good returns

• After periods of high pessimism (negative
sentiment), stock prices are low and thus may offer
good returns

-Optimistic at market top, pessimistic at market bttom

Question 2

What is sentiment based upon?

Answer 2

Social mood cycle

Question 3

What is a Bubble?

Answer 3

Kindleberger 1978 defined it is upward price movement over an extended that then implodes

-a sharp rise in the price of an asset or a range of
assets in a continuous process, with the initial rise
generating expectations of further rises and attracting
new buyers

Question 4

Example of tulip mania bubble (Galbraith 1994)

Answer 4

A semper August bulb sold for 2000 guilders in 1625

-Contract price 20 times higher than in both 1636 November and May 1637

Question 5

Dot-com bubble example

Answer 5

Nasdaq 100 soared to 4816.35 24th March 2000, plunged losing 80%

Question 6

Speculative Bubbles’ life Cycle Galbraith (1994)

Answer 6

• Money functions as an indication of intelligence
• Knapp 1944, little know about innovation prospects, but there exists a positive general predispotion towards it, uncertainty breeds rumours

-Some investors speculate on its prospects from early
on; whether this is due to first-mover propensity or
manipulative intent

• Prices rise due to original euphoria, and the expectant attention (Le Bon 1895)
• Investment delirium, decline in demand, price correation sets in: price slump

Question 7

How does innovation create bubbles?

Answer 7

The innovation could be evolutionary or
revolutionary
• Evolutionary innovations build upon existing
knowledge evolution;

Revolutionary innovations are
breakthroughs in knowledge not existing previously

Question 8

Revolutionary innovation from the Dot-Com bubble

Answer 8

Introduction of the internet, led to interest picks up which forces the price of the shares up this was as a result of extrapolative expectations

Question 9

What are some behavioural explanations of Bubbles

Answer 9

• Anchoring effect
• Over-extrapolation
• Fear of regret, regret of omission and commission for example
• Cognitive dissonance
• Loss aversion

Question 10

What are Ponzi schemes

Answer 10

-A Ponzi scheme is a fraudulent investing scam promising high rates of return with little risk to investors.

Question 11

History on Ponzi schemes

Answer 11

Charles Ponzi offered
investors a 50% return on their investment in 90
days. He claimed that he himself was making a
400% return

Question 12

What are pyramid schemes?

Answer 12

-Specific kind of ponzi scheme

-A classic pyramid operates on the assumption that
some individuals at the ‘top’ will earn money from the
investments of others

• As time progresses, more and more people are needed
to support those in the upper levels

Question 13

What are the two types of pyramid schemes?

Answer 13

Legitimate and illegitimate

Question 14

What are legitimate pyramids?

Answer 14

• Primary purpose is to sell product
• returns to upper levels are from both the sale of product and recruitment of new sales, commison generated from sales and commission from recruits

Question 15

What are illegitimate pyramids?

Answer 15

the return is typically
derived from investments by others and not from sale
commissions

They offer investment returns which sound better than what is offered
in the marketplace
₋
The investors are encouraged to reinvest the profits rather than take a
payoff
₋
The distinguishing feature of the pyramid type of Ponzi schemes is that
old victims are paid back with funds received from new victims

Question 16

What is the important thing that all ponzi schemes have in common?

Answer 16

-To survive they need to use invested funds to pay other investors, they collapse when they start withdrawing

Question 17

Similarities with Ponzi schemes and market bubbles

Answer 17

• overvaluation of
  fundamental asset prices and the market could go
  down or up

-At the beginning of the life of the scheme or
financial bubble, the expected value of investing is thought to be positive

• Stay in market if prices are high in fear of missing out on a golden opportunity
• Might collapse

Question 18

Differences between financial bubbles and ponzi schemes

Answer 18

-Fundamental asset value that the price is based on in bubbles, 0 in ponzi schemes as it is grossly overvalued by promoter

Question 19

What are the 5 types of bubbles?

Answer 19

• Extrinsic
• Rational stochastic bubbles
• Intrinsic bubbles
• Fads
• Informational bubbles

Question 20

What are extrinsic bubbles?

Answer 20

expected fundamentals, plus the expected value of whatever you can sell that asset for in the next period based on all available information

Question 21

What are rational stochastic bubbles?

Answer 21

These have a probability of bursting each period. However, although investors can be sure that eventually the bubble will collapse, they are uncertain as to the timing of that crash.

Question 22

Intrinsic bubbles

Answer 22

the bubble depends upon the fundamentals. So as the fundamentals increase (“improve”), the bubble grows

Question 23

What are fad bubbles

Answer 23

social psychological factors

Question 24

What are informational bubbles

Answer 24

Fundamental value is the value based upon all the information available to all traders.