Speculative Asset Research Articles

Toxic asset bubbles

We develop an overlapping generations model with leveraged investment in speculative asset bubbles. Financial intermediaries use borrowed funds to speculate on a risky asset bubble, which promises high returns as long as it does not collapse. They can, however, default on their debt and shift the losses to lenders when the bubble collapses. This risk shifting leads to welfare-reducing (or “toxic”) rational asset bubbles. We then analyze a set of often discussed policy interventions: pricking bubbles, macroprudential regulations, and leverage restriction.

Central Bank Behaviour Concerning the Level of Bitcoin Regulation as a Policy Variable

Bitcoin gains more and more attention in the general public and is already the most popular virtual currency. At the same time, the acceptance of Bitcoin as a speculative asset and also as a payment vehicle increases. This is an indication that we might now be entering an era of parallel currency systems. Therefore, one could state that the Bitcoin network and the central banking system could become two rival systems with respect to issuing payment vehicles and providing cross-border payment systems. Our aim is to analyse the central bank incentives for establishing a network model that includes hacking. With our model we are able to explain why central banks have no incentive to advance Bitcoin regulation at the current stage of development, as this would reduce the critical mass of Bitcoin users. Finally, in combination with a central bank loss function, we are able to calculate an optimal level of central regulation.

Price Jump Risk in the US Housing Market

Housing prices, like the prices of other speculative assets, contain a mix of both small and large changes (i.e., jumps). We apply a jump-GARCH model to monthly Case-Shiller housing price indexes of twenty cities in the U.S. during the period January 1991 through December 2011. We document the evidence of large housing price jumps in many cities, during both the financial crisis and non-crisis periods. The housing price jump intensity observed during the whole sample is largely explained by city, state and national-level fundamentals. However, consistent with the development of an asset bubble, there is further evidence of a decoupling between housing price jump intensity and fundamentals during the active or turbulent phase of the U.S. housing market that immediately preceded the onset of the Global Financial Crisis. No evidence of a decoupling from fundamentals is observed during the normal or tranquil phase of the U.S. housing market.

Toxic Asset Bubbles

We develop a growth model with credit-fueled speculative asset bubbles. In our model, financial intermediaries (banks) use borrowed money to speculate on a risky asset bubble, which promises high returns as long as the bubble does not collapse. However, with limited liability, banks can default on their debt and avoid absorbing all the losses when the bubble collapses. As a consequence, excessively risky (or “toxic”) asset bubbles can emerge despite the fact that all agents are perfectly rational. We then show that three different policies can improve welfare: an intervention that “pricks” an existing bubble, a macroprudential tax against bubble speculation, or a macroprudential banking regulation.

A Speculative Asset Pricing Model of Financial Instability

I develop a dynamic equilibrium model that incorporates incorrect beliefs about crash risk and use it to explain the available empirical evidence on financial booms and busts. In the model, if a long period of time goes by without a crash, some investors' perceived crash risk falls below the true crash risk, inducing them to take on excessive leverage. Following a drop in fundamentals, these investors de-lever substantially, both because of their high pre-crash leverage and because they now believe future crashes to be more likely. Together, these two channels generate a crash in the risky asset price that is much larger than the drop in fundamentals. The lower perceived crash risk after years with no crashes also means that the average excess return on the risky asset is low at precisely the moment when any crash that occurs would be especially large in size; moreover, it means that, in the event of a crash, some investors may default and banks may sustain large unexpected losses. Finally, the model shows how pre-crash warning signs can generate financial fragility. By reducing investors' optimism, warning signs also increase investors' uncertainty about their beliefs and thereby make them more likely to overreact to future bad news.

Speculative Asset Prices

Robert J. Shiller delivered his Prize Lecture on 8 December 2013 at Aula Magna, Stockholm University.

On the impossibility of insider trade in rational expectations equilibria

Existing no trade results are based on the common prior assumption (CPA). This paper identifies a strictly weaker condition than the CPA under which speculative trade is impossible in a rational expectations equilibrium (REE). As our main finding, we demonstrate the impossibility of speculative asset trade in an REE whenever an insider is involved who knows the asset's true value. To model insider trade as an equilibrium phenomenon an alternative equilibrium concept than the REE is thus required.

Speculative Asset Prices (Nobel Prize Lecture)

Speculative Asset Prices (Nobel Prize Lecture)

Identifying Speculative Bubbles: A Two-Pillar Surveillance Framework

In the aftermath of the global financial crisis, the issue of how best to identify speculative asset bubbles (in real-time) remains in flux. This owes to the difficulty of disentangling irrational investor exuberance from the rational response to lower risk based on price behavior alone. In response, I introduce a two-pillar (price and quantity) approach for financial market surveillance. The intuition is straightforward: while asset pricing models comprise a valuable component of the surveillance toolkit, risk taking behavior, and financial vulnerabilities more generally, can also be reflected in subtler, non-price terms. The framework appears to capture stylized facts of asset booms and busts—some of the largest in history have been associated with below average risk premia (captured by the ‘pricing pillar’) and unusually elevated patterns of issuance, trading volumes, fund flows, and survey-based return projections (reflected in the ‘quantities pillar’). Based on a comparison to past boom-bust episodes, the approach is signaling mounting vulnerabilities in risky U.S. credit markets. Policy makers and regulators should be attune to any further deterioration in issuance quality, and where possible, take steps to ensure the post-crisis financial infrastructure is braced to accommodate a re-pricing in credit risk.

Identifying Speculative Bubbles: A Two-Pillar Surveillance Framework

In the aftermath of the global financial crisis, the issue of how best to identify speculative asset bubbles (in real-time) remains in flux. This owes to the difficulty of disentangling irrational investor exuberance from the rational response to lower risk based on price behavior alone. In response, I introduce a two-pillar (price and quantity) approach for financial market surveillance. The intuition is straightforward: while asset pricing models comprise a valuable component of the surveillance toolkit, risk taking behavior, and financial vulnerabilities more generally, can also be reflected in subtler, non-price terms. The framework appears to capture stylized facts of asset booms and busts—some of the largest in history have been associated with below average risk premia (captured by the ‘pricing pillar’) and unusually elevated patterns of issuance, trading volumes, fund flows, and survey-based return projections (reflected in the ‘quantities pillar’). Based on a comparison to past boom-bust episodes, the approach is signaling mounting vulnerabilities in risky U.S. credit markets. Policy makers and regulators should be attune to any further deterioration in issuance quality, and where possible, take steps to ensure the post-crisis financial infrastructure is braced to accommodate a re-pricing in credit risk.

Asset Price Bubbles in the Perspective of New Keynesian Theory

Developments in the real world depends on human reaction to economic events which is also determined by dominating economic thought. Dominance of neoliberal and monetarist thinking was the main cause of ignoring asset price bubbles and their effects on real economy. New keynesian economic thinking provides an alternative. Hyman Minsky’s model of financial instability was more effectively able to explain super-bubbles in US economy and subsequent ‚Great Recession’. Ignorance of momentum-bias of traders and banks contributed to this crises. Emerging markets and Baltic countries were strongly influenced by credit oversupply in US. Instabilities were so sizeable that IMF approved using capital control and proposal or tax on financial transactions was made. Policymakers and individuals should abandon ignorance of speculative asset price bubbles and improve their analytical skills to recognize bubbles and change their behavior.

Speculation and Risk Sharing with New Financial Assets*

Abstract I investigate the effect of financial innovation on portfolio risks when traders have belief disagreements. I decompose traders’ average portfolio risks into two components: the uninsurable variance, defined as portfolio risks that would obtain without belief disagreements, and the speculative variance, defined as portfolio risks that result from speculation. My main result shows that financial innovation always increases the speculative variance through two distinct channels: by generating new bets and by amplifying traders’ existing bets. When disagreements are large, these effects are sufficiently strong that financial innovation increases average portfolio risks, decreases average portfolio comovements, and generates greater speculative trading volume relative to risk-sharing volume. Moreover, a profit-seeking market maker endogenously introduces speculative assets that increase average portfolio risks.

Financial Innovation and Portfolio Risks

I illustrate the effect of financial innovation on portfolio risks by using an example with risk-sharing needs and belief disagreements. I consider two types of innovation: product innovation, formalized as an expansion of new financial assets; and process innovation, formalized as a reduction in transaction costs. When belief disagreements are large, both types of innovation increase portfolio risks. Moreover, endogenous financial innovation is directed towards speculative assets that increase portfolio risks.

Forecasting the Risk of Speculative Assets by Means of Copula Distributions

The GARCH(1,1) model and its extensions have become a standard econometric tool for modeling volatility dynamics of financial returns and portfolio risk. In this paper, we propose an adjustment of GARCH implied conditional value-at-risk and expected shortfall forecasts that exploits the predictive content of uncorrelated, yet dependent model innovations. The adjustment is motivated by non-Gaussian characteristics of model residuals, and is implemented in a semiparametric fashion by means of conditional moments of simulated bivariate standardized copula distributions. We conduct in-sample forecasting comparisons for a set of 18 stock market indices. In total, four competing copula-GARCH models are contrasted against each other on the basis of their one-step ahead forecasting performance. With regard to forecast unbiasedness and precision, especially the Frank-GARCH models provide most conservative risk forecasts and out-perform all rival models.

Bifurcation analysis of a non-standard finite difference scheme for a time-delayed model of asset prices

In this paper, we apply a non-standard finite difference scheme to a time-delayed model of speculative asset markets and discuss the effect of time delay on the dynamics of asset prices. Firstly, the stability of the positive equilibrium of the system is investigated by analysing the characteristic equation. By choosing the time delay as a bifurcation parameter, we prove that Hopf bifurcations occur when the delay passes a sequence of critical values. Then, the explicit algorithm for determining the direction of the Hopf bifurcations and the stability of the bifurcating periodic solutions are derived. Finally, some numerical simulations are given to verify the theoretical analysis.

A Stochastic Chartist–Fundamentalist Model with Time Delays

A stochastic chartist–fundamentalist model of speculative asset dynamics in financial markets is developed. The model is represented by a stochastic delay-differential equation (SDDE). The SDDE is then solved using approximation and numerical Monte Carlo methods. The results show that for large time delays, the SDDE generates market-like stock price dynamics that reflect the memory effects of the time delay. The resultant dynamics agree with the empirical observation of the tendency of stock markets to deviate from pure random walk.

Global Economic Prospects: The Recession May be Over but Where Next?

Abstract The global economy suffers from a demand gap in large part because of sustained declines in the share of labour income in most major economies. So far the deflationary threat posed by underconsumption has been averted thanks to debt-driven consumption and property investment in the US and several European economies. This has, however, resulted in growing global trade imbalances and financial fragility which has culminated in a global crisis. A return to the pre-crisis pattern of growth could prove to be even more damaging. A US–China rebalancing is necessary but not sufficient to restore stability and growth in the world economy. The two major mature surplus economies, Japan and particularly Germany, which have been siphoning global demand without adding to global growth, will also need to reduce their reliance on exports and add to global demand. Policy Implications • All major economies should pursue full employment policies and higher wage settlements in order to avoid underconsumption crises and sluggish growth. • The US should not allow its economy to be driven by speculative asset and credit cycles. It should live within its means and shift to export-led growth. • China should shift to consumption-led growth by significantly increasing the share of household in GDP through faster wage growth and greater government transfers and by raising public spending on social services. • Germany should stop competitive disinflation and accelerate growth based on domestic consumption.

Leverage and bubbles: a note on the Spanish property market between 1998 and 2006

Financial leverage means the debt taken to make a property investment is revalued in the same proportion as the speculative asset acquired. When the expected price rises above a certain threshold, it becomes rational to take on long-term debt to finance a short-term investment. This causes bubbles, which can have disastrous consequences for the economy as a whole. We model here the economics of speculative leverage and calculate the speculative threshold for the Spanish property market over the last decade, showing how far prices were above the mark.

Income Distribution, Irrational Exuberance, and Growth

The current economic crisis facing the U.S. economy, and thereby the entire world, has its origins in not just the subprime markets but is more of a systemic crisis. Its roots can be found in certain significant economic developments in the United States since the late 1970s: dramatic growth in inequality of income; restricted government sector, especially in the 1990s; growing trade deficit; and declining business investment. Given that the three main sources of demand, and thereby of growth, were declining in importance, the only way that the U.S. economy could have grown was through injection of consumption demand. Here again, an increase in income inequality had the potential of dampening consumption through the route of underconsumption. Therefore, for even the consumption demand to increase there was a need for some external impetus. I present a theoretical model arguing that the growth process in such a situation perforce becomes dependent on speculative asset price markets which have the potential of influencing consumption of households through the wealth effect. It is precisely for this reason that such a trajectory of growth becomes a “bubble in the whirlpool of speculation.” JEL classification: E2, O1, O4

Value, Price and Epic Recession

The concepts, assumptions, and models of contemporary mainstream economics are inadequate for analyzing and explaining the current global financial and economic crisis. The crisis is neither a ‘normal’ (typical post-1945) recession nor yet a classic great depression, but instead represents what is called an ‘epic recession’, which is a specific kind of economic contraction that is precipitated by a major financial system crash with origins in excessive global liquidity, an extended period of speculative financial asset investment, asset price inflation, extreme debt accumulation, and declining real asset investment. The failure of mainstream economics to properly understand the current crisis lies in its misunderstanding of the character and role of asset prices, credit, debt, as well as its inability to differentiate between speculative and non-speculative forms of investment. The origins of epic recessions are not only different from normal recessions, but the evolution and trajectory of epic recessions differ as well. Epic recessions typically result in either an extended period of general economic stagnation, i.e. a ‘Type I’ epic recession (U.S. 1907–1914), or in a ‘Type II’ (U.S. 1929–1931) with a high probability of transitioning to a bona fide depression. To explain epic recession new concepts of global money parade, speculative investment shift, debt-deflation-default nexus, and financial fragility and consumption fragility are introduced as key forces underlying, and integrating, both financial and real economic aspects of the crisis. The analysis of epic recession that follows is undertaken at the level of price categories. However, the article concludes with an exploration of the implications of the analysis for explaining the current crisis at the level of value, in the Marxist sense of that latter term. Suggestions are made how key Marxist ratios of rate of surplus value, organic composition of capital, and falling rate of profit might be extended and expanded to include financial variables, such as credit and debt, in order to better explain the obvious critical role played by finance capital in causing and contributing to the current epic recession.