Week 4 - Financial Bubbles

Question 1

What two markets did we distinguish when we talked about the Bubbles?

Answer 1

• Markets for non-durable consumer goods and services:
• Around 75% of private sector products.
• Participants are either buyers or sellers.
• They do not switch between buyer and seller based on price.
• Trades are final (supplied on demand, no re-trading).
• Stable in the economy and laboratory markets perform also well.
• Efficient (fast) equilibrium price discovery.
• Financial markets:
• Financial instruments (stocks and bonds), but also real estate (houses).
• Participants switch between roles of buyers and sellers.
• Volatile in reality and replicable tendency for price bubbles in laboratories.

Question 2

What is the definition of a Financial Bubble?

Answer 2

Financial bubbles - prolonged periods of rising prices to levels vastly exceeding fundamental (realistic) economic assessments (”booms”). The rising prices are subsequently followed by sharp declines, sometimes even price crashes (”busts”).

Question 3

What factors can affect the financial bubbles?

Answer 3

• Certain dividends (dampens but does not eliminate bubble)
• Professionals as subjects instead of students:
  -Small business owners and mid-level corporate executives.
  -Over-the-counter market dealers and financial advisors.
• Institutional factors such as:
  -Brokerage fees or capital gains taxes.
  -Limits on price changes.
  -Short selling and margin buying.
  -Market size (market with 300 participants behaves the same as markets with 9 participants).

However: Creation of futures market reduces the bubble!

Question 4

According to the Caginalp, Porter and Smith (2001) paper, what factors are shown to dampen the laboratory bubbles with inexperienced subject, and what are their implications?

Answer 4

• Three factors shown to dampen laboratory bubbles with inexperienced subjects:
  -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).
  -Reducing supply of cash via deferred instead of immediate dividend payments.
  -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 5

What are few of the possible explenations for the occurance of financial bubbles we talked about?

Answer 5

Lack of common knowledge of rationality
Subject confusion

Question 6

What does the lack of common knowledge of rationality explenation of financial bubbles tells us?

Answer 6

• 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 7

What is the subject confusion explenation of financial bubbles telling us?

Answer 7

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?
* 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 FV (e.g., Lei and Vesely (2009))
* Seems sufficient to get rid of the bubbles.
Cheung et al (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 8

What is the momentum model introduced by Caginalp et al (2000)?

Answer 8

Restricting initial price to be ”close to ” FV dampens the bubble.

• Investors influenced by (i) fundamental value and (ii) recent price trend.
• When price is below fundamentals, value investors start buying
  -Momentum investors start buying based on increasing price trend
  -As price increases above fundamentals value, investors start selling
  -As trend reverses, momentum investors continue to sell-off
  Implication for IPOs: Initial undervaluation can lead to greater bubble.

Participating for three times in the same experiment with the same group removes the bubble

Question 9

What are the possible explenations for the momentum model?

Answer 9

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 10

How did the Frictions and rational speculators helped drive the dotcom bubble?

Answer 10

• Frictions:
  -Limits to arbitrage: Fundamental/noise trader risk, transaction costs, short-sale constrains …
  -Arbitrageurs cannot eliminate the bubble, prices are driven by investor sentiment.
• 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 constrains: Only coordinated selling effort among arbitrageurs can eliminate the
  bubble.