FINA 3010: FINANCIAL MARKETS

Wenxi JIANG
(Fall 2015)

Lecture Note 11:

Bubbles

© Wenxi Jiang

1
Outline

1. Overview: stylized facts of asset bubbles

2. An explanation of bubbles

Course content
Part I: Financial Assets and Instruments
- Debt
- Stock
- Insurance, futures, and options
Part II: Investor in Financial Markets
- Individual investors
- Institutional investors
Part III: Prices of Financial Assets
- Efficient market hypothesis (EMH)
- Departure from EMH
- Aggregate asset market return
- The cross-section of asset return
- Bubbles

2
Overview

A bubble is an episode where an asset becomes highly overvalued

for a significant period of time
• “Overvalued” means: the asset’s price is higher than it would
be if all investors were fully rational
• That is, the price is hard to justify on the basis of reasonable
forecasts of future cash flows and sensible discount rate

Fact 1: bubbles appear to have occurred quite often throughout

history
• South sea, Mississippi bubbles, 1720
• U.S. stock market, 1920s
• Japan real estate and stock markets, late 1980s
• Asian real estate and stock markets, mid 1990s (Thailand,
Malaysia, Indonesia)
• NASDAQ (high-tech stocks), 1998 to 2000
• U.S. real estate market, 2000s
• The Chinese stock market in 2007 and 2015

Fact 2: bubbles often feature very high trading volume

Case 1: Dot-com bubbles in NASDAQ from 1998 to 2000

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 Figure 1
Prices and Turnover for Internet and Non-Internet Stocks, 1997-2002

120% 1,200

100% 1,000
Average Turnover: Other
Average Turnover: Internet

Equal Weighted Return Index (Dec 1996 = 100)

Return Index: Other
Return Index: Internet
80% 800
Monthly Turnover (%)

60% 600

40% 400

20% 200

0% 0
Dec-96

Mar-97

Jun-97

Sep-97

Dec-97

Mar-98

Jun-98

Sep-98

Dec-98

Mar-99

Jun-99

Sep-99

Dec-99

Mar-00

Jun-00

Sep-00

Dec-00

Mar-01

Jun-01

Sep-01

Dec-01

Mar-02

Jun-02

Sep-02

Dec-02
Source: Hong and Stein (2003)

Case 2: The Chinese stock market in 2006 to 2007

Notes: The underlyingStock
Shanghai data isExchange
from the Center
IndexforandResearch in Security
Turnover Rate Prices (CRSP)
(monthly)
database. We use the same sample of internet stocks as Ofek and Richardson (2003).
Their sample is obtained from lists of “pure” internet companies published by Morgan
7000 0.3
Stanley, available on Eli Ofek’s home page at <http://pages.stern.nyu.edu/~eofek/>. For
each month, we divide the set of all common stocks listed on CRSP into “internet” and
6000 0.25
“all other” portfolios, and calculate average monthly turnover and price indices for these
5000
two categories. Our turnover and price level indices are equal-weighted, but the results
0.2
are qualitatively similar using market-capitalization weights.
4000
0.15
3000
0.1
2000

1000 0.05
32
0 0
2003m11

2004m11

2005m11

2006m11

2007m11

2008m11
2003m7
2003m9

2004m1
2004m3
2004m5
2004m7
2004m9

2005m1
2005m3
2005m5
2005m7
2005m9

2006m1
2006m3
2006m5
2006m7
2006m9

2007m1
2007m3
2007m5
2007m7
2007m9

2008m1
2008m3
2008m5
2008m7
2008m9

Monthly Turnover Rate Shanghai Composite Index

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• Understanding bubbles is an urgent challenge
- When they collapse, unsophisticated investors often lose
significant wealth
- And the economy often falls into recession

Interpretation
• The rational framework has difficulties explaining the episode
of bubbles in asset prices
• Economists have proposed several explanations from the
behavioral/institutional approach
- A convincing explanation needs to reconcile both facts
- i.e., over pricing and high trading volume

Here, I introduce one of them – disagreement and short-sale

constraint
• In this framework, bubbles are the result of intense
disagreement across investors about the future prospects of an
asset
• This framework is classified as “behavioral” because, in
financial markets, large sustained disagreement usually
requires some overconfidence
- i.e., people draw their information from different sources
and are convinced that their source is the best

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• disagreement, on its own, does not lead to overpricing or
bubbles
- but, when coupled with a short-sale constraint, it does

Two channels:
(1) when there is a short-sale constraint, bearish investors do not
hold the asset
- the asset is held only by optimists, and is therefore
overpriced
(2) when there is disagreement, investors buy the asset not just
because they are optimistic about its future cash flows
- but because they think they can resell the asset to other,
even more optimistic investors in the future
- this extra source of demand helps to generate a bubble
- and also helps to generate trading volume

Note:
This approach explains not only why assets can become
overpriced (Fact 1), but also why there is very high trading
volume during bubbles (Fact 2)

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 Evidence: The Chinese warrant bubble

Warrants are over priced compare to its fair value based on the
Black-Scholes formula
- The reason that investors still want to buy the warrant is
that investors hope to sell it later to other investors at an
2730 even higher price
THE AMERICAN ECONOMIC REVIEW OCTOBER 2011

80
Strike
(left scale)
8

Warrant price
(left scale) 60

6
Warrant price

Stock price
40
Stock price
4 (right scale)

20
2

Fundamental
Black−Scholes price upper bound
(left scale) (left scale)
0 0
Apr06 Jul06 Oct06 Jan07 Apr07 Jul07 Oct07 Jan08 Apr08

Figure 1. Prices of WuLiang Put Warrant

Notes: This figure shows the daily closing prices of WuLiang stock and its put warrant, along with WuLiang war-
Source:
rant strike price,Xiong
upper and Yuof
bound (2011)
its fundamental value assuming WuLiang stock price drops 10 percent every day
before expiration (maximum allowed per day in China’s stock market), and its Black-Scholes price using WuLiang
stock’s previous one-year rolling daily return volatility.

warrant was traded at prices above the Black-Scholes value throughout its life,
except for a brief two-week period in the beginning. For convenience, we say7 that
the Black-Scholes value is zero if it falls below an economically negligible level,
marked at 0.05 penny (half of the minimum trading tick of 0.1 penny). The warrant’s
Reference

Hong, Harrison, and Jeremy C. Stein. "Disagreement and the Stock Market" Journal of
Economic perspectives 21.2 (2007): 109-128.

Xiong, Wei, and Jialin Yu. "The Chinese Warrants Bubble." The American Economic Review
101.6 (2011): 2723.