Bubbles and Contagion in Financial Markets, Volume 1 (eBook)

Eva R. Porras (Budapest, Hungary) is a financial and business consultant, providing financial expertise to numerous multinational businesses. She is currently serving as Head Consultant for Business Valuation SL in Spain; Habitat Property Partners in Budapest and is part time Finance Director for Gotham Producciones Tematicas, Budapest, and has over two decades of experience working in financial institutions and corporations, including for Fox and Citibank. She has held a distinguished academic career, and was Academic Dean of the Central European University Business School in Budapest, Hungary, and previously, Director of Master Programs in Finance at the Instituto de Empresa in Madrid, Spain.

Cover 1
Bubbles and Contagion in Financial Markets, Volume 1 4
Contents 8
List of Tables and Figures 9
Preface 12
Acknowledgments 17
List of Acronyms 18
1 Introduction to Bubbles and Contagion 20
1.1. Current situation 20
1.2. Definitions 22
1.2.1. Contagion definition 22
1.2.2. Bubble definition 24
1.3. Brief history and analysis of some bubbles 25
1.3.1. Tulip Mania 25
1.3.2. South Sea Bubble (1719–1720) 27
1.3.3. Railway Mania 29
1.3.4. Dot-com Bubble 30
1.3.5. The housing bubble 33
1.4. Causes of bubbles and contagion 36
1.4.1. Conditions 38
1.4.2. Bounded rationality 38
1.4.3. The financial accelerator 40
1.4.4. Herding 40
1.4.5. Trade linkages 41
1.4.6. Financial linkages 41
1.5. The life cycle of a bubble 42
1.5.1. Phases of a bubble’s life cycle 43
1.5.2. Resulting misallocations 46
1.5.3. Balance-sheet recession 48
2 Macro “Players” in Bubble Formation and Contagion Processes 50
2.1. Monetary and fiscal policy 50
2.2. Credit, global flows, and the repricing of risk 53
2.3. Connectivity, systemic risk sharing, and transmission mechanisms 57
2.3.1. Connectivity and exposures 57
2.3.2. The financial accelerator’s role in the transmission of crises 65
2.3.3. Economic instability and financial risk 67
2.3.4. Systemic risk and transmission mechanisms 68
2.3.4.1. Creditor/depositor runs 70
2.3.4.2. Information-induced bank runs 70
2.3.4.3. Collateral/margin runs 71
2.3.4.4. Loss spiral 71
2.3.4.5. Margin/haircut or leverage spiral 71
2.3.4.6. Contagion and flight to safety 72
2.3.4.7. Lenders’ limitations 72
2.3.4.8. Network externalities 72
2.3.4.9. Feedback effects between financial sector risk and sovereign risk 73
3 Contributors to the Bubble Formation and Contagion Process 74
3.1. Market imperfections 74
3.2. Asymmetric information 75
3.2.1. Improved stock liquidity 77
3.2.2. Reduced cost of capital 78
3.2.3. Increased information intermediation 78
3.3. Self-fulfilling expectations and reflexivity 78
3.3.1. Reflexive relations 80
3.3.2. Feedback, collective behaviors, and herding 82
3.4. Executive compensation and bad incentives 83
3.5. Speculative trading 86
3.6. Aspects of behavioral finance 87
3.6.1. Rational choice and bounded rationality 87
3.6.2. A dual-system theory: intuition and accessibility 88
3.6.3. Framing effects 90
3.6.4. Attribute substitution: a model of judgment by heuristic principles 91
3.6.5. Changes or states: standard utility versus Prospect Theory 92
3.6.6. Applying behavioral economics to financial markets143 97
3.6.6.1. Preferences 98
3.6.6.2. Beliefs 101
3.6.6.3. Decision-making process 102
3.7. Biases, strategies, competition, market failures, policy, and regulation 104
3.7.1. Information asymmetries 105
3.7.2. Externalities and cross-subsidies 105
3.7.3. Root causes and remedies for problems 106
3.7.4. Practical challenges for interventions 108
4 Bubbles versus the Valuation of Fundamentals 109
4.1. The role of “expectations” 109
4.2. Detecting bubbles 114
4.3. Fundamentals of valuation 118
4.3.1. Accounting value 125
4.3.2. Discounted cash flow value 125
4.3.3. Residual value 127
4.4. Methods used to assess the business value of corporations 130
4.4.1. Methods based on asset value 131
4.4.1.1. Book value and adjusted book value 131
4.4.1.2. Liquidation value 131
4.4.2. Methods based on stock exchange ratios 132
4.4.2.1. The P/E ratio 132
4.4.2.2. Dividend yield 133
4.4.2.3. Market capitalization 133
4.4.3. Methods based on discounted cash flows 133
4.4.3.1. Dividend discount method 133
4.4.4. Method based on discounted expectations 134
4.4.5. Models based on shareholder value creation 134
4.5. Components of fundamental analysis 135
4.5.1. Sensitivity analysis 136
4.5.2. Seasonal analysis 137
4.5.3. Nonfinancial analysis 137
4.5.4. Real options 137
4.5.5. Result and evaluation of the analysis 138
4.5.5.1. Management model 138
4.5.5.2. Medium- and long-term strategy 139
4.5.5.3. Final comments on valuation 139
4.6. The fundamentals of economic value creation 141
4.6.1. Accounting profit and economic value are two different things 142
4.6.2. Growth does not equate to economic value creation 143
4.6.3. Value creation requires a reference to the future and implies risk 143
4.6.4. Value creation is not an easy or short-term task 144
4.6.5. The role of communication in value perception 144
5 Bubbles and Technical Trading 145
5.1. Introduction to technical analysis 145
5.1.1. Fundamental versus technical analysis 146
5.1.2. Brief history of technical analysis 147
5.1.3. Criticism of technical analysis 148
5.2. The basics of technical analysis 149
5.2.1. The chart in technical analysis 150
5.2.2. The trend 155
5.2.3. Support and resistance 156
5.2.4. Gaps 158
5.2.5. Volume 158
5.3. Chart patterns in technical analysis 159
5.3.1. Head and shoulders 159
5.3.2. Cup and handle 160
5.3.3. Double tops and bottoms 160
5.3.4. Triangles 161
5.3.5. Flag, pennant, and wedge 161
5.3.6. Moving averages in technical analysis 162
5.3.7. Indicators and oscillators14 in technical analysis and strategy 164
5.4. Chart analysis 166
5.5. Fibonacci 167
5.5.1. Fibonacci in technical analysis 168
5.5.1.1. Fibonacci retracements 168
5.5.1.2. Fibonacci arcs 169
5.5.1.3. Fibonacci fans 170
5.5.1.4. Fibonacci time zones 170
5.6. Market predictions based on wave patterns, Elliott Waves 170
5.6.1. Wave levels 173
5.6.2. Fractal nature 174
5.6.3. Rules and guidelines 174
5.6.4. Criticisms 176
5.7. Does technical analysis help identify trading opportunities? 178
5.7.1. Prices are random 178
5.7.2. Trend-chasing in creating bubbles 184
5.7.3. The self-fulfilling prophecy and bubbles 188
6 Contagion 190
6.1. Background on crises and contagion 190
6.2. Channels of propagation: the empirical evidence 193
6.2.1 Financial linkages 193
6.2.2 Common creditors and capital flow linkages 195
6.2.3 Trade linkages 197
6.2.4 The surprise element 197
6.3. Social learning, information cascades, and herding 197
6.3.1 Social learning 197
6.3.2 Information cascades and herding 199
6.4. Theories of contagion 201
6.4.1 Herding and cascades 202
6.4.2 Noise trader models 205
6.4.3 Behavioral models 208
6.4.3.1 Differences of opinion and short-sale constraints 210
6.4.3.2 Feedback trading 210
6.4.3.3 Biased self-attribution 211
6.4.3.4 Representativeness heuristic and conservatism bias 212
6.4.3.5 Bubbles in experimental settings 212
6.4.4 Recent generation of studies 213
6.4.4.1 Reputational herding 214
6.4.4.2 Limited liability 215
6.4.4.3 Perverse incentives 216
7 Bubbles 217
7.1. Introduction 217
7.2. An overview of bubbles 222
7.2.1. Rational and near-rational growing bubbles 224
7.2.1.1. Models 225
7.2.1.2. Sunspots 228
7.2.2. Fads 229
7.2.3. Information bubbles 232
7.2.4. Bubbles in experimental settings 233
7.2.5. Related accounting literature 234
7.3. A partial history of the classical literature on bubbles 235
7.4. Frequently asked questions about bubbles 243
7.4.1. How are bubbles started? 243
7.4.2. Why do bubbles implode? 245
7.4.3. What are the consequences? 246
7.4.4. Should the government intervene? 247
Notes 252
Preface 252
1. Introduction to Bubbles and Contagion 252
2 Macro “Players” in Bubble Formation and Contagion Processes 256
3. Contributors to the Bubble Formation and Contagion Process 259
4. Bubbles versus the Valuation of Fundamentals 271
5. Bubbles and Technical Trading 273
6. Contagion 277
7. Bubbles 285
Author Index 292
Subject Index 295