Rational speculative bubbles in the gold futures market: An application of dynamic factor analysis

Abstract

The existence of speculative bubbles in financial markets has been a longstanding issue under debate. Many financial economists believe that, given the assumption of rational expectations and rational behavior of economic agents, an asset should be priced according to its “market fundamentals.” Others argue that self-fulfilling rumors of market participants can influence asset prices as well. These self-fulfilling rumors are initiated by events extraneous to markets and are often called bubbles. The rationality of both expectations and behavior often does not imply that the price of an asset be equal to its fundamental value. In other words, there can be rational deviations of the price from this value—rational bubbles. A rational 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. Under such conditions, the arbitrary, self-fulfilling expectation of price changes may drive actual price changes independently of market fundamentals; we refer to such a situation as a rational price bubble.1 © 2001 John Wiley & Sons, Inc. Jrl Fut Mark 21:79–108, 2001