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Asset pricing with financial bubble risk

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  • Lee, Ji Hyung
  • Phillips, Peter C.B.

Abstract

This paper characterizes systematic risk stemming from the possible occurrence of price bubbles and measures the impact of this additional risk factor on asset prices. Historical stock market behavior and recent empirical experience have led economists and policy makers to acknowledge that price bubbles in financial markets do occur and need to be accounted for in risk analysis. New econometric tools for analyzing mildly explosive behavior (Phillips and Magdalinos, 2007; Phillips et al., 2011) have made it possible to detect the presence of bubbles in data and to date stamp their origination and collapse, providing empirical confirmation of such episodes in recent data. The potential for price bubbles and market collapse provides another source of stock market risk and adds to the risk premium. We provide an analytic and empirical investigation of this additional risk factor. The standard present value model is extended to allow for possible price bubbles and the effects of integrating bubble behavior into a consumption-based asset pricing model are analyzed. The theory involves attention to the investor time horizon and a study of the validity of conventional log linear approximations in the presence of nonstationary and mildly explosive data. Finite decision horizons accommodate myopic investors and are a component of speculative behavior that focuses on short run market gains rather than long run effects of fundamentals. An econometric approach to estimate bubble risk effects is developed and the methods are applied to composite stock market index data, giving new model-based equity premium and market volatility estimates that more closely match the data than traditional consumption based asset pricing models.

Suggested Citation

  • Lee, Ji Hyung & Phillips, Peter C.B., 2016. "Asset pricing with financial bubble risk," Journal of Empirical Finance, Elsevier, vol. 38(PB), pages 590-622.
  • Handle: RePEc:eee:empfin:v:38:y:2016:i:pb:p:590-622
    DOI: 10.1016/j.jempfin.2015.11.004
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    References listed on IDEAS

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    Cited by:

    1. Jose Eduardo Gomez-Gonzalez & Sebastian Sanin-Restrepo, 2017. "The Maple Bubble: A History of Migration among Canadian Provinces," Borradores de Economia 992, Banco de la Republica de Colombia.
    2. Park, Alex & Lappas, Petros, 2017. "Evaluating demand charge reduction for commercial-scale solar PV coupled with battery storage," Renewable Energy, Elsevier, vol. 108(C), pages 523-532.
    3. Petr Makovský, 2016. "The relationship between the real economy and financial sector regarding technological bubbles," Ekonomika a Management, University of Economics, Prague, vol. 2016(3).
    4. repec:gam:jecnmx:v:5:y:2017:i:4:p:47-:d:115992 is not listed on IDEAS
    5. Su, Chi-Wei & Li, Zheng-Zheng & Chang, Hsu-Ling & Lobonţ, Oana-Ramona, 2017. "When Will Occur the Crude Oil Bubbles?," Energy Policy, Elsevier, vol. 102(C), pages 1-6.
    6. Daan Steenkamp, 2017. "How bubbly is the New Zealand dollar?," Reserve Bank of New Zealand Discussion Paper Series DP2017/03, Reserve Bank of New Zealand.
    7. Andras Fulop & Jun Yu, 2017. "Bayesian Analysis of Bubbles in Asset Prices," Econometrics, MDPI, Open Access Journal, vol. 5(4), pages 1-23, October.

    More about this item

    Keywords

    Asset pricing; Bubbles; Financial market anomalies; Log linear approximation; Mildly explosive time series; Present value model;

    JEL classification:

    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
    • C22 - Mathematical and Quantitative Methods - - Single Equation Models; Single Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes

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