Irrational Exuberance Research Articles

Stock Market Volatility and Mathematical Expectations

It is generally believed that excessive stock market volatility reflects non-mathematical market expectations that are driven by “irrational exuberance” or “animal spirits”. As shown in this paper, there is an alternative explanation. If ex-ante and ex-post expectations are calculated in different stochastic processes, uncertainty can cause mathematical market expectations to be more volatile than their fundamentals.

The Effectiveness of Prudential Regulations for Banks: Global Perspective and Indian Context

Banking regulations intend to protect the interest of depositors, reduce the risk of bank failures, minimize the moral hazard, and strengthen the financial stability by controlling the behavior of financial system participants and by building financial buffers. In countries like India, where banks dominate the financial sector, banking regulations assume added significance. This paper provides a global perspective on the prudential regulations and examines the extent to which the regulations could mitigate the risk of financial crises. It also analyses the role of macro-prudential regulations in achieving financial stability and its interaction with micro-prudential regulations. It further delves into the role of regulations in catalyzing financial innovations and hence, indirectly contributing to irrational exuberance and excessive risk-taking in the financial system. Certain other issues deliberated upon in this paper include a need to closely look at the nature and design of prudential regulations with a view to reducing complexities in regulatory and supervisory processes, and evaluation of the role of regulations in growth, governance, and performance of banks in India. The paper looks at the movement of credit to GDP ratio, the GDP growth trajectory, and a periodic emergence of credit gap in the Indian context, and discusses the utility of credit gap as an indicator for macroprudential policy in India. This paper also analyses the pattern and movement of gross and net NPAs of the Indian banks and its relations with regulatory forbearance and supervisory processes. It suggests a continual need for strengthening institutional credibility for improving the effectiveness of regulatory and supervisory processes so as to achieve stability, transparency, and robustness in financial institutions and financial markets.

Skewness Preference: Specialized Knowledge, Preference for Lotteries, or Deviations from Rational Expectations Equilibriums?

Suppose Rational Expectations Equilibriums (REE) that are inferred at time t materialize at time t+1. This study provides formal theoretical and empirical evidence that performance effects of skewness preference simultaneously can be evidence for demonstrations of full rationality (expertise), or acceptance of gambles on huge payoffs that have low probabilities of occurrence (preference for lotteries). In presence of incidence of unanticipated realizations of market frictions, market imperfections, or behaviors of alternate economic agents that induce deviations, at time t+1, from REE that are inferred at time t, a strictly concave relation between performance and skewness preference is consistent with investor rationality. A novel result is the finding that skewness preference induces largest benefits for portfolio performance in context of portfolios that are indicative of presence of some specialized knowledge, but yet are relatively diversified. Totality of study findings demonstrates skewness preference is not necessarily evidence for behavioral biases, trade-offs with risk aversion, preference for lotteries, or irrational exuberance; show skewness preference can, in entirety be fully rational, yet in presence of deviations from REE, appear to be less than fully rational.

The Impact of Uncertainty and Certainty Shocks

I propose a Bayesian quantile VAR to identify and assess the impact of uncertainty and certainty shocks, unifying Bloom's (2009) two identification steps into one. I find that an uncertainty shock widens the conditional distribution of future real economic activity growth, in line with a risk shock. Conversely, a certainty shock (a shock strongly decreasing uncertainty) narrows the conditional distribution of future real activity growth. In addition to the difference in signs, I show that the two shocks are different shocks. Each shock impacts the real economy uniquely. I support this with the underlying events: For instance, uncertainty shocks relate to events such as Black Monday and 9/11, but also to fears about future negative economic outcomes. In contrast, certainty shocks often link to phases of irrational exuberance. Commonly, no distinction is made between uncertainty and certainty shocks. I show that uncertainty shocks become more important if distinguished from certainty shocks.

The gap in CS, mulling irrational exuberance

The Communications Web site, http://cacm.acm.org, features more than a dozen bloggers in the BLOG@CACM community. In each issue of Communications , we'll publish selected posts or excerpts. twitter Follow us on Twitter at http://twitter.com/blogCACM http://cacm.acm.org/blogs/blog-cacm Carl Hewitt suggests computer science needs a reference resource, while Vijay Kumar decries intellectual dishonesty in technology forecasting.

Unleashing Animal Spirits: Self-Control and Overpricing in Experimental Asset Markets

One explanation for overpricing on asset markets is a lack of traders’ self-control. We implement the first experiment to address the causal relationship between self-control and systematic overpricing on financial markets. Our setup detects some of the channels through which low individual self-control could transmit into irrational exuberance in markets. Our data indicate a large direct effect of reduced self-control on market overpricing. Low self-control traders report stronger emotions after the market.

Efficient Derivative Pricing and Sequestered Capital

The efficient market hypothesis implies that the price of a financial derivative should mirror the value of its underlying asset(s). This model is used to reconsider an historic anomaly—the large, allegedly irrational, premia on investment trusts that preceded the 1929 crash. First, we reexamine evidence—highly cited for decades—alleging anomalous premia on portfolio-publishing trusts preceding the crash. Our assessment, based on current information-gathering capabilities, shows no evidence of anomalous premia in the cases considered. Secondly, we test our model on a data set of over 3,000 price observations, using regression discontinuity in time (RDiT) designs. As expected, the prices of blind trusts quickly corrected with the disclosure of their underlying portfolios. Our findings suggest that sequestered capital, rather than irrational exuberance, was primarily responsible for the premia on trusts in 1929.

A Tale of Two Countries: Comparing the US and Chinese Housing Markets

The recent surge in property values in China has been similar to the surge in the U.S before the crash in 2007. This raises concerns about whether China is destined to have a crash as well. We estimate similar models of property values for the two countries, in order to compare price dynamics side by side. We find little in common between them. In the U.S. the adjustment process appears prone to “bubbles” in the sense of strong momentum, but Chinese prices have been generally mean reverting, without momentum. This suggests that the recent price rise in China has had more to do with scarcity than with irrational exuberance.

Determinants of Bank Profitability in the Euro Area: What Has Changed During the Recent Financial Crisis?

During the recent financial crisis, bank profitability has become an element of strong concern for regulators and policymakers; in fact both self-financing strategies and capital increases – necessary to provide higher level of capitalization – rely on the ability of a bank to generate profits. However, the determinants of bank profitability, that seemed to be unequivocally identified by previous literature, appear to have changed under the effect of regulatory and competitive dynamics. We test this hypothesis on commercial, cooperative and saving banks, employing a random effect panel regression on a dataset comprising bank-level data and macroeconomic information (covering the period 2006-2013) for 9 countries of the Euro area. Our findings suggest that, after a period of “irrational exuberance” in which credit growth and high leverage were seen as proper and fast ways to boost profitability, a sound financial structure and a wiser and objective credit portfolio management have become the main drivers to ensure higher returns.

How banks and other financial institutions think

AbstractConventional diagnoses of the 2007/8 Global Financial Crisis see it as “abnormal”, and then resort to explanations in terms of “irrational exuberance”, “animal spirits”, “herding behaviour” and so on. The prescription – “better regulation” – then follows automatically, as it has done after every such crisis, all the way back to tulipmania 400 years ago. But if there are different “seasons of risk”, and if financial sector actors are able to latch onto different risk-handling strategies, each appropriate to one of those seasons and inappropriate to the others, then we have a very different explanation: one in which, in contrast to both neoclassical and behavioural economics, rationality is no longer singular. This “anthropological” hypothesis has its roots in Mary Douglas’s book “How Institutions Think”, and the paper shows how it is well supported by historical evidence, agent-based modelling, and fieldwork among both financial sector firms and their regulators, as well as by parallels from ecology, organisation theory and evolutionary (i.e. Schumpeterian) economics.

Unleashing Animal Spirits - Self-Control and Overpricing in Experimental Asset Markets

One possible determinant of overpricing on asset markets is a lack of self-control abilities of traders. Self-control is the individual capacity to override or inhibit undesired behavioral tendencies such as impulses and to refrain from acting on them. We implement the first experiment that is able to address a potential causal relationship between self-control abilities and systematic overpricing on financial markets by introducing an exogenous variation of self-control abilities. Our experimental conditions seek to detect some of the channels through which individual self-control problems could transmit into irrational exuberance on the aggregate level. We observe a strong effect of inhibited self-control abilities on market overpricing. Our findings are furthermore robust to reducing self-control abilities only for a moderate share of traders in a market. Low self-control traders engage in more speculative behavior early on, but because others imitate their trading patterns, they do not end up earning less and are not driven out of the market.

Mind, Body, Bubble! Psychological and Biophysical Dimensions of Behavior in Experimental Asset Markets

Asset market bubbles and crashes are a major source of economic instability and inefficiency. Sometimes ascribed to animal spirits or irrational exuberance, their source remains imperfectly understood. Experimental methods can isolate systematic deviations from an asset's fundamental value in a manner not possible on the trading floor. In this chapter, we review evidence from dozens of laboratory experiments that investigate the measurement and manipulation of an array of psychological and biophysical attributes. Measures of emotion self‐regulation and interoceptive ability are informative, as is cognitive ability and the level and fluctuation of hormones.Rules that promote deliberative decision making can improve market efficiency, while incidental emotions can impair it. Signals in specific brain areas can be a trigger precipitating a bubble's collapse. We conclude that trading decisions are profoundly biophysical in a manner not captured by efficient markets models, and close with speculations on implications for algorithmic trading.

Artificial Intelligence: The Importance of Trust & Distrust

Artificial Intelligence (AI) is percolating through modern society. Just as technology made the leap from analog to digital, and communications catapulted forward from rotary dial telephones to smartphones, FaceTime, and WhatsApp, AI has gone from needing hundreds of square feet of computers for the task of playing chess to identifying faces with a thumbnail of silicon. Most important, one cannot overemphasize the speed at which we are hurtling towards a world in which AI will be ubiquitous, seeping into every corner of what we do. As AI becomes part of our everyday life, a key aspect will be the way in which society—and by extension, the legal system—manages both the integration of these systems and society’s expectations. In this context, this essay suggests that the concepts of trust and distrust will be critical for navigating the road ahead, particularly if we want to avoid societal unrest and upheaval. We will have to learn to trust the capacity of AI systems sufficiently so that we can soar to new heights without succumbing to the irrational exuberance that can send us crashing to the ground when our hopes are dashed by its inability to live up to our blind expectations. And we must learn to tolerate the ambiguity that lies between these two extremes. To accomplish these goals, this essay suggests three general principles that should form the basis of the legal regimes—both regulatory and property—that will be necessary for AI.

Rethinking Asset Bubbles: Reflections for the Age of Institutional Investing

Upon surveying a contentious topic that has occasioned much debate, this paper offers reflections on the likelihood that asset booms, bubbles and busts continue posing a threat to financial stability despite financial markets becoming increasingly informationally-efficient, complete, and heavily influenced by sophisticated (presumably rational) investors. Rather than arise from widespread behavioral irrationality as is commonly assumed, this paper suggests procyclical mispricings stand to increasingly reflect institutional frictions — benchmarking, incentive and organizational design pressures — in the rapidly-growing institutional investment industry. These influences may make bubble riding ‘rational,’ or at the very least, discourage institutions from leaning against the wind. Moreover, even in the absence of leverage, systemic risk could increasingly be shaped by large shifts in risk premia owing to the rational herding motivations of institutional investors. To the extent procyclicality owes less to ‘irrational exuberance’ and more to performance evaluation practices, traditional countercyclical policy measures could be of reduced efficacy unless reinforced by reforms to institutional incentives.

Big Fish: Valuation of the World’s Largest Salmon Farming Companies

During the last six years, the salmon stock price index at the Oslo Stock Exchange has increased by nearly ten times. This article attempts to shed some light on the reasons why this substantial stock price appreciation has taken place. The primary aim is to ascertain if the market valuation of salmon farming companies can be explained by rational factors, or if there is an element of irrational exuberance behind the current all-time high salmon stock prices. In particular, we seek to uncover if a structural break has occurred in the market value formation of salmon stocks. The results suggest that a structural shift has occurred, leading to a stronger association between fundamentals and market valuations after 2012, indicating that at least some of the substantial stock price increase during 2012–2016 can be attributed to fundamental factors.

'Big Fish': Valuation of the World's Largest Salmon Farming Companies

The recent five years have seen a nearly tenfold increase the salmon stock price index at the Oslo Stock Exchange. This paper tries to shed some light on the reasons why this substantial stock price appreciation has occurred. The primary aim is to ascertain if the market valuation of salmon farming companies can be explained by rational factors, or there is an element of irrational exuberance behind current all-time high salmon stock prices. In particular, we examine the impact of both fundamental and operational value drivers. The results suggest that a structural shift has occurred, leading to a stronger association between fundamentals and market valuations after 2012, suggesting that at least some of the stock price increase is linked to fundamental factors.

Revising Equity Valuation with Tail Risk

When VIX—a market index of volatility—increases, a firm’s response is to defer growth of investment. Simultaneously, the expected time to ruin, E ( T ), shortens, causing the firm’s value to decline more than commonly used valuation models suggest. The authors derive the characteristics of E ( T ) and revise valuation models that assume cash flows are growing perpetuities. They find that “value trap,” high-growth stocks, and “irrational exuberance” can be explained by incorporating E ( T ) into the traditional valuation models. Their empirical results show that the sensitivities of the 49 industry portfolios to the change in VIX are all significantly negative and undiversifiable and could be proxies for E ( T ).

Does March Madness lead to irrational exuberance in the NBA draft? High-value employee selection decisions and decision-making bias

We use detailed, personally-assembled data on the performance of collegiate and professional basketball players over the 1997–2010 period, to look at the impact of performance in the NCAA “March Madness” college basketball tournament on NBA teams’ draft decisions and players’ ultimate success in the NBA. We find that unexpected March Madness (MM) performance, in terms of team wins and player scoring, affects draft decisions, and NBA personnel who are making these draft decisions are not irrationally overweighting this MM information. If anything, the unexpected performance in the March Madness tournament deserves more weight than it gets in the draft decisions.

Catch Animal Spirits in Auction: Evidence from New Zealand Property Market

AbstractFollowing the animal spirits theory proposed by Akerlof and Shiller, this article contributes to behavior economics by investigating the possibility of using auction sales data to capture evidence of irrational exuberance in the housing market. Using the monthly percentages of residential property auction sales for Auckland, Wellington and Christchurch regions in New Zealand from 2006 to 2015, and the exuberance testing method proposed by Phillips, Shi and Yu, we find that animal spirits have been developing in the Auckland housing market since 2013, but not in other regions. When compared to the results based on price‐to‐rent ratios, auction sales provide more meaningful results for identifying market‐wide irrational exuberance at an early stage. The causality test on price‐to‐rent ratios and auction sales volume shows that asset prices and animal spirits influence each other in the short run. In the long run, prices have significant effect on animal spirits, but not vice versa.

Samuelson's Analysis of the Extreme Variability and Relative Unpredictability of Investment, Due to the Uncertainty of Investment Expenditures, Leads to the Rejection of the Post Keynesian-Davidsonian Claim that Samuelson Was Not a Keynesian

Samuelson’s eighth edition of his Economics presented an excellent elaboration on and explanation of Keynes’s overall analysis in the General Theory. Samuelson covered the reasons why a “free” market, Laissez Faire economy, operating with minimal government, would never be able to provide a full employment amount of investment in real capital. Thus, Investment spending will always be ”highly variable” and “relatively unpredictable “unless counteracted by the appropriate mix of necessary expansionary and contractionary fiscal and monetary policies over time. Samuelson covered the connection between expectations and uncertainty, as well as covering the real possibility of a liquidity trap, where the impact of a collapse of confidence in expected returns from durable investment results in a liquidity preference “uncertainty floor”, where monetary policy can’t work because of the interest rate bound of 0 %.Samuelson treated uncertainty as extrinsic uncertainty .Hence ,the impact of uncertainty is modeled as occurring outside the pure, formal, economic model based on microeconomics alone. It is modeled as creating unexpected and unanticipated, large shifts in the relevant microeconomic demand and supply curves. These shifts cause Investment expenditures, at the aggregated macro level, to be ” highly variable” and “relatively unpredictable” over time, leading to involuntary unemployment unless counteracted by continuous and vigorous government (public) intervention. There is no “Invisible Hand” that will allow the private sector to self adjust internally by itself. At the micro level, the result will be a “very slowly adjusting disequilibrium” that could require decades to eliminate, assuming that there are no other uncertain impacts that occur in the intervening period of time while the adjustment process to the initial uncertain event takes place. If uncertainty is pervasive, then the initial disequilibrium is never eliminated because another uncertain event impacts the economic system before such adjustment can take place. The private sector is thus in a permanent state of disequilibrium due to ambiguity about the business cycle, expectations, irrational exuberance,innovation, technological change, the threat of obsolescence, etc., that cause the mec schedule to shift unpredictably through time.Samuelson’s mastery of chapter 12 of the General Theory allowed him to accurately predict the Dot.com implosion and recession of 2000-2001 in 1996 (Cover,Kindleberger, 3rd edition). Predictions with comparable accuracy to Samuelson’s would be American Brigadier General Billy Mitchell’s 1924 prediction that sometime in the future at 7:30 AM on a Sunday morning, the Japanese Imperial Navy will launch a surprise attack on Pearl Harbor from aircraft carriers and Bertrand Russell’s prediction in 1948 that a man would be landed on the Moon by 1975.