Abstract
We inspect the price volatility before, during, and after financial asset bubbles in order to uncover possible commonalities and check empirically whether volatility might be used as an indicator or an early warning signal of an unsustainable price increase and the associated crash. Some researchers and finance practitioners believe that historical and/or implied volatility increase before a crash, but we do not see this as a consistent behavior. We examine forty well-known bubbles and, using creative graphical representations to capture robustly the transient dynamics of the volatility, find that the dynamics of the volatility would not have been a useful predictor of the subsequent crashes. In approximately two-third of the studied bubbles, the crash follows a period of lower volatility, reminiscent of the idiom of a “lull before the storm”. This paradoxical behavior, from the lenses of traditional asset pricing models, further questions the general relationship between risk and return.
Highlights
Economic bubbles are generally defined as periods when financial assets are traded in high volume, and at prices significantly higher than the fundamental value (Galbraith, 2009; Kindleberger, 1978; Shiller, 2006; Sornette, 2017)
We will classify the stock market bubble, ending in the October 1987 crash, as a fearless, leveraged bubble, the former meaning that there was no rise in volatility during the bubble period leading up to the crash, the latter meaning that the bubble was fed by credit growth, or leverage, in the economic system
We identify the stock market bubble, ending in the July 1998 crash, as a fearless, non-leveraged bubble, the former meaning that there was no rise in volatility during the bubble period leading up to the crash, the latter meaning that the bubble was not caused by a rise in credit, or leverage, in the economic system
Summary
Economic bubbles are generally defined as periods when financial assets are traded in high volume, and at prices significantly higher than the fundamental value (Galbraith, 2009; Kindleberger, 1978; Shiller, 2006; Sornette, 2017). The succession of bubbles and crashes that resulted from this include, amongst others, the worldwide stock market bubble followed by the great crash of October 1987, the savings and loans crisis of the 1980s, the burst in 1990-1991 of the Japanese stock market and real estate bubbles, the emerging markets bubbles and crashes in 1994 and 1997, the Long-Term Capital Management (LTCM) crisis of 1998, the Dotcom bubble bursting in 2000, the house price bubbles and resultant credit, stock market, commodities, oil and debt bubbles and subsequent crashes in 2007-2008 All of these developed jointly, feeding upon each other until 2008, when the financial system came close a total collapse (Sornette and Cauwels, 2014).
Sign-in/Register to view highlights & summary Sign-in/Register to access full text options 
Free) 
Talk to us
Join us for a 30 min session where you can share your feedback and ask us any queries you have
Schedule a call
