Economics of Financial Markets
A bubble is an economic cycle in financial markets characterized by a rapid expansion in an asset’s price followed by a contraction. Bubbles happen when the asset price is much higher than its real value because of over-speculation for various reasons. When no more investors are willing to pay the overvalued price, people are to sell the assets and the bubble bursts.
Inflation and bubbles are all the product’s socio-economic development. It is also the result of too much money chasing too few goods. Bubbles are the excessive flow of social money into a particular trading area. From the perspective of effect, people generally feel the decrease of wealth during the period of inflation; The emergence of bubbles tends to make people have the wrong feeling about increased wealth. These phenomena are difficult to avoid because economic subjects can use the money freely and the nature of pursuing interests.
The world’s first financial bubble happened in 1637, called ‘Tulip Mania.’ Excessive speculation on the price of tulips increased the cost of a single tulip bulb to ten times more than the annual income of a skilled craftsman. Finally, the price plunged in a single week, which left many tulip holders bankrupt. ‘Stock Market Crash’ of 1929 and ‘Dot-Com Bubble’ in the 1990s have also occurred in the following years.
The existence of rational bubbles can explain why bubbles arise and why they burst from the perspective of the formula.
Firstly, we introduce some definitions:
R=the return on the asset
P=the price of the asset
D=divident income earned on the asset
We already know that:
……formula (1)
Taking expectations at time t:
…… equation (2)
when is very small. When we assume there is a constant expected return k, then (2) becomes:
……formula (3) and
The price of the asset equals the fundamental value of the asset plus the value of the bubble, and it could be expressed as:
……formula (4)
Taking forward one period and then taking expectations we obtain:
……formula (5)
Substituting formula (5) into formula (3) we have:
…… equation (6)
Equation (6) can be reduced to:
……formula (7)
By comparing formula (4) and formula (7), we can find out that the condition of the rational bubble is whether formula (8) holds. When the present value of the bubble in the next period equals to the amount of the bubble today, the bubble is rational. Otherwise, it is irrational.
……formula (8)
According to equation (8), it is clear that the bubble component of the price should grow at the expected rate of return of the asset. Under the circumstances, rational investors are willing to overpay for an asset because they expect the bubble to grow under the rate to deliver them the same return on the bubble component as they get on the asset’s fundamental price. Over time, the cost of both assets and bubbles would be higher until nobody wants to pay for the inflated prices.
Four main theories are explaining how financial bubbles can arise in financial markets and why they burst. The first thing to be considered is ‘The Greater Fool Theory.’ According to this theory, over-optimistic market agents (the fools) buy overvalued assets at a higher price than its fundamental value, intending to sell them at a much higher price to other market agents (the greater fools) who have even higher or over-optimistic expectations on the costs of the assets. The key to speculation is to judge whether there is a greater fool than you. As long as you are not the biggest fool, then you are the winner. As time goes on, the price of such over-valued assets keeps increasing with fools buying and selling to other greater fools until the bubble bursts when no greater fools are willing to buy them.
Secondly, it is the ‘Extrapolation theory.’ Extrapolation in bubble terms means projecting past prices into the future on the same basis. Investors believe that the asset’s cost will continue to increase in the future at the same rate as in the past under certain conditions. Extrapolation causes investors to overbid some risky assets in an attempt to maintain and achieve the same past return rates. However, overbidding leads to a lower return. Finally, the whole process comes to an end when investors found that profits are no longer positive when all costs of the investments are taken into consideration, and then the bubble bursts.
‘Herding theory’ also plays a significant role in explaining the generation of the bubbles. Herb behavior in financial markets is a unique irrational behavior, where it refers to investors being influenced seriously by other investors. Investors imitate others’ decisions or excessively relying on public opinions without considering their information under uncertain information circumstances. Investors detect market trends and follow them by buying and selling in the direction of the market. This fact is not only found on individuals but also institutional investors classify it. If some of the companies enter into a bubble, outside investment managers will join as well since investment managers’ performance is usually evaluated relative to their competitors.
Last but not least, it called ‘Moral Hazard Theory.’ According to the theory, when someone is protected from the risk, they might behave differently than if they were not protected and fully exposed to the dangers. Moral hazard usually happens when the risk-return relationship is altered or when an emergency problem occurs like a bailout. When a company makes an inappropriate decision, which leads to an extremely negative impact, the company might have an incentive to undertake a level of risk above his control or seemingly irrational. Such behavior would produce instability to the financial markets, and the bubble occurs as a consequence if he were fully exposed to the risk without any protection.
Asset price bubbles are bound to burst, and the bigger the bubble, the higher the fission. The bubble bursts principle is limited social capital stock, which leads to limited social capital into the asset trade. The bigger the bubble is, the higher the future asset price will be, and the more social capital inflow will be needed. When the rate of capital inflow cannot meet the needs of the rising cost, the bubble will burst. There is a massive contrast between the limited social capital inflow to transactions and the unlimited demand for capital from bubbles. There will always be a time when supply is less than demand, and then bubbles burst; this is the root cause of the inevitable bursting of any asset bubble.
In conclusion, bubbles are not a rare phenomenon in financial markets. There are four main reasons for bubbles. It is still a manifestation of economic imbalance, which causes severe negative impacts on the market. It will lead to a specific financial crisis if this economic phenomenon can not be dealt with effectively. So, effective measures should be taken to prevent the next bubble by making sure that the economy can develop steadily and healthily for the government or relative authorities.