Summary: Session 4 Financial Bubbles

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• 1 Session 4: Financial Bubbles

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• what are Financial bubbles

  Financial bubbles - prolonged periods of rising prices to levels inconsistent with fundamental (realistic) economic assessments. The rising prices are subsequently followed by sharp declines, sometimes even price crashes. Prolonged periods, i.e. not the same as flash crashes.

• Distinguishing two kinds of markets.what 2 markets are these?

  1 Markets for non-durable consumer goods and services:
  Around 75% of private sector products. Participants know in advance whether they are buyers or sellers. They do not switch between buyer and seller based on price. Trades are final (supplied on demand, no re-trading). Stable in the economy and laboratory markets perform also well. Efficient (fast) equilibrium price discovery.
  
  
  2 Financial markets:
  Financial instruments (stocks and bonds), but also real estate (houses). Participants switch between buyers and sellers. Volatile in reality and replicable tendency for price bubbles in laboratories. Performed far worse in laboratories than expected.

• First global financial bubble Frehen, Goetzmann and Rouwenhorst (2013):what do they consider?

  Frehen, Goetzmann and Rouwenhorst (2013): considerable cross-sectional variation in the extent of price run-up.

• Experimental studies on financial bubbles Caginalp, Porter and Smith (2000) basic experimental setup:What are 7 things that are considered to be part of the experimental setup?

  Finite life: an asset pays dividends for 15 periods (calculate value).
  
  Uncertain dividend with four potential payoffs: 0, 8, 28, 60.
  
  Expected dividend each period 24 units.
  
  The initial fundamental value is 360 (=24 x 15).
  
  Initial cash and shares distributed to participants.
  
  Double auction or call market trading mechanism.
  
  Experiment repeated with same traders.

• Experimental studies on financial bubbles.what effect does experience have here?what are factors that are not affected by a bubble?

  Experimental studies on financial bubbles
  
  1 Experience: Participating for three times in the same experiment group removes the bubble.  the first time experience deviates alot from the fundamental value, the second time experienced group also differ from it.
  
  2 The creation of a bubble is not affected by these factors:
  Bubbles still occur even with a certain dividend. Informed insiders cannot stop the bubble: they sell everything by period 11. Replacing students with following groups: - Advanced graduate students in economics and game theory. - Small business owners and mid-level corporate executives. - Over-the-counter market dealers and financial advisors.

• Institutional conditions and financial bubbles.name 2 that do influence a bubble creationname 2 that do not influence a bubble creation

  Institutional conditions and financial bubbles
  
  1 Institutional factors that do NOT influence the bubble creation: Brokerage fees have no effect on amplitude, duration and volume of trading. Capital gain taxes also have no effect. Limits on price changes unfortunately increase the duration.
  
  2 Institutional factors that DO influence the bubble creation: Short selling affects the trading volume, but less the duration and amplitude. Creation of a future market reduces the bubble.

• Summary experiments and financial bubbles The price in an experimental setting changes due to:name 3 reasons as to why the prices change in an experimental setting

  1 Neoclassical theories: price changes occur only in response to a deviation from the fundamental value of the asset.
  
  2 As prices rise beyond the fundamental value, the traders become aware that other traders are making decisions based on factors beyond valuation alone.
  
  3 The demand and supply are dependent in part on the price change, or derivative, of the asset price.

• Caginalp, Porter and Smith (2001) Three conditions that could reduce the market bubble:name 3 conditions that could reduce the market bubble.

  1 Low initial liquidity level: Influence the trading through the net ratio of supply and demand. IPO float (supply of stock). Implementation: manipulate the supply of available cash.
  
  2 Deferred dividends: Dividends are paid only at the end of the experiment. Reduce the supply of cash.
  
  3 Bid-ask book open to traders: Traders can see the orders of others. Traders can incorporate different views in the pricing.

• Caginalp, Porter and Smith (2001):Conclusion and implications  .name a conclusions with respect to this research?what are three factors that can influence a laboratory bubble?what are the implications of these the results of the Caginalp, Porter and Smith (2001) paper?

  1 Changes in price cannot be attributed to uncertainty about the expected payout and must therefore be related to the uncertainty about the actions of other traders.
  
  2 Three factors can influence a laboratory bubble: Low cash-to-asset ratio. Differed dividend payments. Opening of the book with bid-ask orders by participants.
  
  3 Implications:
  Momentum trading strategies can result in bubbles and crashes.
  IPOs: initial undervaluation leads to greater bubble.
  Discounts on closed-end mutual funds due to excess supply.
  Quantitative easing by central banks can create bubbles.

• What is being done in the Hussam, Porter and Smith (2008)  paper? what are the name of the previous studies?

  Combine the previous two studies and examine whether the error elimination by market experience is robust to changes in the environment. 
  
  Caginalp, Porter and Smith. 2000 and 2001.