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From rational bubbles to crashes

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  • Sornette, D
  • Malevergne, Y

Abstract

We study and generalize in various ways the model of rational expectation (RE) bubbles introduced by Blanchard and Watson in the economic literature. Bubbles are argued to be the equivalent of Goldstone modes of the fundamental rational pricing equation, associated with the symmetry-breaking introduced by non-vanishing dividends. Generalizing bubbles in terms of multiplicative stochastic maps, we summarize the result of Lux and Sornette that the no-arbitrage condition imposes that the tail of the return distribution is hyperbolic with an exponent μ<1. We then outline the main results of Malevergne and Sornette, who extend the RE bubble model to arbitrary dimensions d: a number d of market time series are made linearly interdependent via d×d stochastic coupling coefficients. We derive the no-arbitrage condition in this context and, with the renewal theory for products of random matrices applied to stochastic recurrence equations, we extend the theorem of Lux and Sornette to demonstrate that the tails of the unconditional distributions associated with such d-dimensional bubble processes follow power laws, with the same asymptotic tail exponent μ<1 for all assets. The distribution of price differences and of returns is dominated by the same power-law over an extended range of large returns. Although power-law tails are a pervasive feature of empirical data, the numerical value μ<1 is in disagreement with the usual empirical estimates μ≈3. We then discuss two extensions (the crash hazard rate model and the non-stationary growth rate model) of the RE bubble model that provide two ways of reconciliation with the stylized facts of financial data.

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Bibliographic Info

Article provided by Elsevier in its journal Physica A: Statistical Mechanics and its Applications.

Volume (Year): 299 (2001)
Issue (Month): 1 ()
Pages: 40-59

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Handle: RePEc:eee:phsmap:v:299:y:2001:i:1:p:40-59

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Web page: http://www.journals.elsevier.com/physica-a-statistical-mechpplications/

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References

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  1. Y. Malevergne & D. Sornette, 2001. "Multi-dimensional rational bubbles and fat tails," Quantitative Finance, Taylor & Francis Journals, vol. 1(5), pages 533-541.
  2. D. Sornette, 2000. ""Slimming" of power law tails by increasing market returns," Papers cond-mat/0010112, arXiv.org, revised Sep 2001.
  3. Shleifer, Andrei, 2000. "Inefficient Markets: An Introduction to Behavioral Finance," OUP Catalogue, Oxford University Press, number 9780198292272.
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Citations

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Cited by:
  1. John M. Fry, 2009. "Statistical modelling of financial crashes: Rapid growth, illusion of certainty and contagion," EERI Research Paper Series EERI_RP_2009_10, Economics and Econometrics Research Institute (EERI), Brussels.
  2. Fry, J. M., 2009. "Bubbles and contagion in English house prices," MPRA Paper 17687, University Library of Munich, Germany.
  3. Szafarz, Ariane, 2012. "Financial crises in efficient markets: How fundamentalists fuel volatility," Journal of Banking & Finance, Elsevier, vol. 36(1), pages 105-111.
  4. Fry, J. M., 2010. "Bubbles and crashes in finance: A phase transition from random to deterministic behaviour in prices," MPRA Paper 24778, University Library of Munich, Germany.
  5. Brière, Marie & Chapelle, Ariane & Szafarz, Ariane, 2012. "No contagion, only globalization and flight to quality," Journal of International Money and Finance, Elsevier, vol. 31(6), pages 1729-1744.
  6. Choi, Jaehyung, 2012. "Spontaneous symmetry breaking of arbitrage," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 391(11), pages 3206-3218.
  7. D. Sornette & A. Johansen, 2001. "Significance of log-periodic precursors to financial crashes," Papers cond-mat/0106520, arXiv.org.
  8. Jaehyung Choi, 2011. "Spontaneous symmetry breaking of arbitrage," Papers 1107.5122, arXiv.org, revised Apr 2012.
  9. D. Sornette, 2000. ""Slimming" of power law tails by increasing market returns," Papers cond-mat/0010112, arXiv.org, revised Sep 2001.
  10. W. -X. Zhou & D. Sornette, 2002. "Evidence of a Worldwide Stock Market Log-Periodic Anti-Bubble Since Mid-2000," Papers cond-mat/0212010, arXiv.org, revised Aug 2003.
  11. Fry, J. M., 2010. "Gaussian and non-Gaussian models for financial bubbles via econophysics," MPRA Paper 27307, University Library of Munich, Germany.

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