We develop a rational expectations model of financial bubbles and study ways in which a generic risk-return interplay is incorporated into prices. We retain the interpretation of the leading Johansen-Ledoit-Sornette model, namely, that the price must rise prior to a crash in order to compensate a representative investor for the level of risk. This is accompanied, in our stochastic model, by an illusion of certainty as described by a decreasing volatility function. The basic model is then extended to incorporate multivariate bubbles and contagion, non-Gaussian models and models based on stochastic volatility. Only in a stochastic volatility model where the mean of the log-returns is considered fixed does volatility increase prior to a crash.
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Paper provided by Economics and Econometrics Research Institute (EERI) in its series EERI Research Paper Series with number
EERI_RP_2009_10.
Find related papers by JEL classification: C00 - Mathematical and Quantitative Methods - - General - - - General E30 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - General (includes Measurement and Data) G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
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