The Demand for New Risky Equity and Prices in Public Equity Markets

Abstract

This study models price equilibriums that feasibly could obtain within stock markets. In all, the model generates five feasible price equilibriums. Given the equilibrium most attractive to issuers is characterized by presence of rational valuation bubbles, formal predictions show stock prices are prone to development of rational valuation bubbles. In presence of arrival of new innovations within stock markets prior to exhaustion of innovativeness of `previously new' innovations, rational valuation bubbles are maintained ad infinitum. If arrival rates for new innovations lag exhaustion rates for previously new innovations, stock markets experience market correction events. As reasonably could be expected, the formal model provides evidence for feasibility of irrational valuation bubbles within stock markets. Consistent with expectations, where they occur, irrational bubbles are larger in magnitude than corresponding rational bubbles. In this respect, formal predictions show evolution of return processes can be efficient, yet be generated by less than fully rational or irrational game theoretic actions undertaken by issuers or investors at some origin point in time. The study generates two test statistics for rationality of price equilibriums within stock markets, test statistics which, consistent with normative characterization of such statistics, embed jointness of stock prices and returns.