There have been different views between Economists and financial market participants upon the valuation of an asset. Economists believe that the price of an asset should reflect the fundamental value given the assumption of rational behavior and of rational expectations. On the other hand, financial market participants believe that the fundamental value is part of the asset price. Thus, Markets participate will interpret a positive price volatility as the herd behavior. However in the past they were unable to interpret the excess volatility which was followed by the collapse of the market.
Some of the major crashes such as Tulip mania, the South Sea Bubble, Mississippi Bubble and the Great Crash of 1929 have induced researches to concentrate their study on asset price volatility. Asset price volatility shows by how much an asset deviates from its fundamental value i.e. the risk with is attached to an asset. During the above listed crashes, the volatility rate was very high, as a result researches found the presence of bubble in the assets.
Bubble can be defined as a state of rising asset prices. Once a peak price is attained there may be substantial decrease in the price. A famous example will be the South Sea Bubble whereby the stock value of the South Sea Company rose by over 700% during the first half of 1720. And at the end of 1720, the price fell back to about fifty percent of its value at the start of the year.
The existence of bubbles can be depicted by comparing the fundamental value with the market value of an asset. The fundamental value of an asset means the share price should include information about the present and future return of the asset i.e. the discounted present and future cash flows. The bubble component reflects the value which is actually bigger than the present value of expected future price.
Moreover, bubbles affect the riskiness of the market and it may also contribute to the fluctuations of the macroeconomic variables as it had been the case during the occurrence of the October 1929 Wall Street Crash and the Great Depression. It is interesting to note that bubbles create excess demand in the market while supply remains constant. Therefore, in other words, there will be a shortage and this will lead to an increase in the share price.
Most models of market behavior are based on rational expectations, which assume that:
If any of the condition listed above is violated, bubbles may arise. Bubbles may be classified into speculative bubbles and speculative bubbles cover two kinds of bubbles: rational bubbles and irrational bubbles. There will be irrational bubble if the first one is violated whereas the violation of the second condition will give rise to irrational bubbles.
The theory of rational bubbles demonstrates that, even with rational expectations, asset price deviations from the fundamental value would be possible. The growth of rational bubbles reflects the presence of self-fulfilling expectations about future increases in the asset price. A common feature of the market will be that investors buy an asset only with expectation that it could be resold in the future at a higher price to another investor who is willing to purchase the asset for the same reason.
In an irrational bubble, market participants may focus on “noise” instead of fundamentals. Some noise or unsophisticated traders in a market may overwhelm rational or sophisticated investors if the time horizons for arbitrage are finite.
How Bubble was created
Overinvestment and malinvestment may create bubbles in the market. Overinvestment means investing in too many capital assets to meet the required demand. On the contrary, malinvestment means investing in the wrong capital assets to produce goods and services. A most recent example will be Asian Financial Crises 1997. The Chinese Government injected a lot of assets in the red chips companies in the expectation to increase the share price. The stock price did increase but it did not last for last as a bubble was being created.
It is arguable that the market is not efficient if there exists bubble in the market more precisely speculative bubbles. A speculative bubble can be distinguished as a persistent rise in the price of an asset. The initial rise creates forecasts of further rises and attracting new buyers, in general speculators interested in the rise of the price of the asset rather than in its use or its potential incomes.
However, studies have show that despite the presence of speculative bubbles, the market is efficient. The share price has effectively deviates from the fundamental value but it does not have necessarily violated the efficient market hypothesis. In other words, the prices comprise of all available information about the present and future return taking into account the bubble component. Further, rationality of behavior and of expectations, together with market clearing, imply that assets are voluntarily held and that no agent can, given his private information and the information revealed by the prices, increase his expected utility by reallocating his portfolio.
The following assumptions must be meant in order for a market to be efficient in spite of the presence of bubbles:
Self-fulfilling expectation of investors helps to develop bubbles. These may include herd behavior, panics, manias and among others. It is often argued that choice of an investor is based on the information derived by observing the actions of other investors i.e. they behave in herd. Thus, investors ignore their own information and rely on the uninformed choice of the previous investors. As such, they will try to acquire asset which is highly traded or which other investors are purchasing. In this event there will be bubble in the market and this will lead to an abnormal increase in the price.
Moreover, a future increase in price will attract investors, they will thus buy low and sell high in the future and be realizing a capital gain. However, their common action will create excess demand for the share in the market leading to an equal increase in share prices assuming that supply is constant. This is an event that will create bubbles.
Growth of Bubbles
Rational bubbles may grow at a rate r each period but this may not be necessary the case. The rate r represents the growth rate at which a price increases normally. Notably, if traders are risk-averse, bubbles will grow faster than the rate of r, effectively paying traders a risk premium in the expected value to hold the asset i.e. they are being compensated for holding additional amount of risk.
Growing bubbles may have harmful real effects on the economy by inefficient supply at high prices or making asset prices poor signal. Bubbles also harm welfare because they redistribute wealth, but random redistribution is only harmful if traders are risk-averse since risk-averse traders will avoid a bubble which grows at a rate r.
A bubble may grow at a negative rate in some periods for example when it bursts or in all periods where the discount rate is negative. However the bubble component for price may not be negative as investors have the choice to dispose of the asset and also the price of an asset can not become negative at a future date.
Effects of Bubbles
Initially the price of a stock is considered to be at equilibrium, with a marginal product of capital equal to interest rate. In the absence of bubble, the value of the share can be said to be the replacement cost and the firm has no incentive to increase its number of stocks. Suppose that a bubble starts on its shares, increasing the price, say by 8%. In order to reconcile the price, the firm should add value to the capital stock until the marginal product has been reduces by 8% and the market price will equal to the fundamental value. On the other hand, if the firm issues more shares, this will help the bubble to grow and burst in the future. Further, at a certain price level no one will be willing to purchase the stock and thus creating an excess of supply in the market, leading to a substantial decrease in the value of the stock.
How bubbles can be rule out.
The major problem with bubble in asset prices is that you never know when it is going to burst. Further the burst of the bubbles will affect the market as a whole as evidence can be taken for the past crashes. Several ways can be adopted to rule out a bubble from the market. Many countries have even enacted laws in order to protect themselves from such a framework. For example, the South Sea Bubble caused the British Parliament to pass the South Sea Act which effectively eliminated the stock market as a source of funds for over a century and in the United States, the Great Crash of 1929 led to the creation of the SEC and the introduction of numerous regulations. There are also other ways in which bubbles can be rule out of the market.
Firstly, firms can impose an upper limit on the stock prices and stock should be issued in response to stock price increases. Secondly short selling may help to cancel out the bubble effect. This is in the sense that a positive bubble will attract agents to short sell the assets. At the same time, they will invest some of the proceeds to pay for the stream of dividend and as such there will be positive wealth left over and arbitrage would rule out bubbles.
The study of bubbles behavior can be classified as direct or indirect test. Indirect test was used to study the difference between the actual price and the fundamental value. However the main problem remain on the interpretation part as the effect of bubble in stock prices could not be distinguished from the effects of unobservable market fundamentals. On the other hand, direct test try to directly test for the presence of bubbles. As such researchers try to identify the type of bubble that is present in the market and hence carry out the test accordingly.
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