13 - Bubbleology and financial markets

Abstract

A bubble is an upward price movement over an extended range that then implodes. An extended negative bubble is a crash. So, a bubble is a situation where the price of an asset differs from its fundamental market value. With a rational bubble, investors can have rational expectations that a bubble is occurring because the asset price is above its fundamental value but continue to hold the asset anyway. They might do this because they believe that someone else will buy the asset for a higher price in the future. In a rational bubble, asset prices can therefore deviate from their fundamental value for a long time because the bursting of the bubble cannot be predicted, and so there are no unexploited profit opportunities. A bubble can arise when the actual market price depends positively on its own expected rate of change, as normally occurs in asset markets. Since agents forming rational expectations do not make systematic prediction errors, the positive relationship between price and its expected rate of change implies a similar relationship between price and its actual rate of change. In such conditions, the arbitrary, self-fulfilling expectation of price changes may drive actual price changes independently of market fundamentals.