Rational Bubbles. Evidence from the UK and the US Closed – End Funds Discount.

Abstract

The bubble theory is controversial to the efficient market hypothesis. According to the efficient market hypothesis there is no asset mispricing. All information is incorporated into the asset prices and there are no deviations from the fundamental value. The NAV price of the closed-end funds should reflect a value equal to its share price. Unfortunately, in reality there are deviations and the prices of most closed-end funds are traded at a discount. The bubble theory could explain the discount persistence as prices could increase or decrease substantially without minor or major price corrections of the US and the UK stock market. There is an upward or downtrend trend of large overvaluations or undervaluation’s that creates deviations of the NAV prices from the fundamental value of the fund. Possible explanations that creates the bubble phenomenon and especially when the bubble burst are the discount persistence, the limits of arbitrage, the psychological theory, underreaction – overreaction, arbitrageurs and noise traders. We propose a rational bubble model that could explain the discount persistence. If there is noise in the model, then, it is manifested by a low probability number and the bubble theory and effect persists. In contrast, if there are transparent and efficient trades in terms of strong form of market efficiency the probability will be very close to 1 and there is no bubble effect.