Asset Pricing Bubbles Under Rational Expectations

Abstract

The Efficiency Market Hypotheses (EMH) imply rational investors and no asset mispricing in the medium run. This paper critically evaluates on the point of whether an asset price bubble is an irrational phenomenon that cannot be detected. Thereby, I review the existing literature and reflect on asset pricing tests to detect bubbles. I show that the emergence of rational bubbles within the EMH framework is indeed possible as long as a number of assumptions is not violated. As researchers show, these assumption do not hold in practice, which means that rational bubbles can be ruled out. Thus, a bubbles is always an irrational phenomenon that can be explained with behavioural models such as feedback trading and herding. This implies that EMH does not hold. Hence, irrational bubbles can only emerge in inefficient markets. Models trying to detect bubbles fail to identify the existence of bubbles ex ante and ex interim. Ex post, they can prove that a bubble had existed.