Bubbles and Contagion in Financial Markets, Volume 2 (eBook)

Eva R. Porras (Madrid, Spain) 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 the Director of the International Programs in the Business School of the Universidad Internacional de La Rioja in Spain. Doctor Porras has over three decades of experience working in financial institutions and corporations, including for CBS/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.

Bubbles and Contagion in Financial Markets, Volume 2 2
Preface 5
Acknowledgements 10
Contents 11
Acronyms 15
List of Figures 17
List of Tables 19
1 Asset Price Dynamics and Stochastic Processes 20
1.1Asset Price Dynamics 20
1.2Information and Data 22
1.2.1Times Series Data 23
1.2.2Cross-Sectional Data 23
1.2.3Panel Data 24
1.3Volatility 25
1.4Trading Mechanisms 26
1.4.1Limit Order Markets 26
1.4.2Floor Markets 27
1.4.3Dealer Markets 28
1.4.4Auctions as Clearing Mechanisms 28
1.5Price Prediction 29
1.5.1Transparency 31
1.5.2Liquidity 31
1.6Prices and Returns 32
1.7Analysis and Forecast Models 37
1.7.1Regression Analysis 39
1.7.1.1 Simple Regression 40
Linear functions 44
Exponential Functions 45
Logarithmic functions 46
1.7.1.2 Multiple Linear Regressions 47
1.7.1.3 Assumptions and Violations Underlying the Classical Regression Model 49
1.7.2Analysis of Time Series 57
1.7.3Random Walk 62
1.7.3.1 ARIMA Processes and Modeling 67
1.7.3.2 ARCH, GARCH Processes and Modeling 69
2 Stylized Facts of Financial Markets and Bubbles 71
2.1Introduction to Stylized Facts 71
2.1.1Definition 71
2.1.2Asymptotic and Convergence 73
2.1.3Modes of Convergence of Random Variables 75
2.2Stylized Facts of Financial Markets 78
2.2.1Introduction 78
2.2.2Statistics of Financial Time Series 81
2.2.3Returns 82
2.3Stylized Facts of Bubbles 84
2.3.1Introduction 84
2.3.2Relationships Between Stylized Facts 86
2.3.2.1 Volatility and Volume 86
2.3.2.2 Returns and Volume 87
2.3.2.3 Volatility and Returns 88
3 Introduction to Contagion and Bubbles 89
3.1Rational Choice Theory and Bayesian Learning Tools 93
3.1.1Utility Maximization 96
3.1.2Binary Prediction Tasks by Humans 97
3.1.3Probability 98
3.2Kolmogorov’s Probability Calculus 100
3.2.1Objectivism Versus Subjectivism 107
3.2.2Frequentist Versus Bayesian Probability 107
3.2.3Bayesian Inference 108
3.2.4Bayes’ Simple Form 112
3.2.5Extended Form 114
3.2.6Bayes’ Theorem for Continuous Random Variables 115
3.3Continuous Uniform Probability Spaces 116
3.3.1Simple Form 117
3.3.2Extended Form 118
3.3.3Odds Form 118
4 Rational Social Learning 121
4.1Introduction 121
4.1.1The Binary Model 126
4.1.2The Gaussian Model 129
4.2Rational Social Learning—Opinion Creating 132
4.2.1Martingales and Convergence of Beliefs 132
4.2.2Rational and Non-rational Learning 135
4.2.3Lux (2008) Work on Kirman’s 1993 Model of Opinion Formation and Speculation 135
4.2.4Youngsters and Old Timers in a Gaussian Model 142
5 Bubbles 147
5.1Introduction to Bubbles 147
5.1.1Present Value Review 150
5.1.2Rational Bubbles: Simple Characterization 154
5.1.3Stochastic Bubbles 156
5.2Bubbles, Rational Expectations, and Financial Markets 158
5.2.1The Birth of Rational Bubbles 158
5.2.2The Variance of p 163
5.2.3Stock Prices and Changes in Dividends 164
5.2.4Fat Tails and Runs 166
5.3Rational Bubbles: Rational Expectations Equilibrium (REE) 168
5.3.1Speculation Under Rational Expectations 170
5.3.2Diverse Information 171
5.3.3Static Rational Expectations Equilibrium (REE) 171
5.3.4Dynamic Speculation: Stock Market with Heterogeneous Information 172
5.3.5Bubbles in Myopic REE Market with Heterogeneous Information 173
5.3.5.1 Example of a myopic REE with bubble 174
5.3.6Fully Dynamic REE 174
5.4The “No-Trade” Theorem Under Rational Expectations 175
5.4.1Definition of REE 176
5.4.2Proposition of a No-Trade Theorem 176
5.4.3Asset Bubbles and Overlapping Generations 177
5.4.4Bubbles and Fads in Asset Prices 178
5.4.5Stock Prices and Social Dynamics 180
5.5The Efficient Markets Hypothesis 181
5.6The Theory of Rational Bubbles in Stock Prices 186
5.7Explosive Rational Bubbles in Stock Prices 190
5.7.1Empirical Evidence on Rational Bubbles 190
5.7.2Market Inefficiencies: Noise Trader Risk 194
5.7.3The Limits to Arbitrage 198
5.7.3.1 Fundamental Risk 199
5.7.3.2 Noise Trader Risk 199
5.7.3.3 Synchronization Risk 200
5.7.4The Overpricing Hypothesis 201
5.7.5Market Inefficiencies: Noise Trader Risk 202
5.7.5.1 Demand Functions 204
5.7.5.2 Equilibrium Price 205
5.7.5.3 Relative Expected Returns 206
5.8Market Inefficiencies: Financial Intermediation 209
5.8.1A Model for Credit 209
5.8.1.1 A Model for Credit 210
5.8.1.2 The Optimization Problem 210
5.8.1.3 Fundamental Value 212
5.8.1.4 Existence of Bubbles 212
5.9Bubbles, Financial Instability and Financial Fragility 214
5.9.1Equilibrium 214
5.9.2Heterogeneous Beliefs: Static Model 216
5.9.3Heterogeneous Beliefs: Dynamic Model in Discrete Time, Dynamic Speculation in Discrete-Time (Harrison and Kreps, 1978) 218
5.9.4Heterogeneous Beliefs: Overconfidence and Speculative Bubbles 221
5.9.5Asset Price Bubbles in Complete Markets 226
5.10No Free Lunch with Vanishing Risk (NFLVR) Holds 233
5.10.1No Free Lunch Vanishing Risk (NFLVR) and Full Theorem of Asset Pricing (FTAP) 235
5.10.1.1 Full Theorem Of Asset Pricing (FTAP) 236
5.11Bubbles in Complete Markets 236
5.11.1No Dominance 236
5.11.2Fundamental Value in Complete Markets, the Framework for Modeling Bubbles 236
5.11.3Bubbles in Complete Markets 237
5.11.4Bubbles Decomposition Theorem 237
5.11.4.1 A Summary of Issues Discussed 238
6 Fundamental Versus Contagion Variables to Explain Returns 249
6.1Data and Methodology 258
6.2Methodology 261
6.2.1Pooled OLS Estimation 263
6.2.2Random and Fixed Effects Estimation 264
6.2.3Quantile Regression 266
6.3Results 267
6.4Conclusion 274
Index 276