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Role of diversification risk in financial bubbles


  • Wanfeng YAN

    (ETH Zurich)

  • Ryan WOODARD

    (ETH Zurich)

  • Didier SORNETTE

    (ETH Zurich and Swiss Finance Institute)


We present an extension of the Johansen-Ledoit-Sornette (JLS) model to include an additional pricing factor called the “Zipf factor”, which describes the diversification risk of the stock market portfolio. Keeping all the dynamical characteristics of a bubble described in the JLS model, the new model provides an additional information about the concentration of stock gains over time. This allows us to understand better the risk diversification and to explain the investors’ behavior during the bubble generation. We apply this new model to two famous Chinese stock bubbles, from August 2006 to October 2007 (bubble 1) and from October 2008 to August 2009 (bubble 2). The Zipf factor is found highly significant for bubble 1, corresponding to the fact that valuation gains were more concentrated on the large firms of the Shanghai index. It is likely that the widespread acknowledgement of the 80-20 rule in the chinese media and discussion fora led many investors to discount the risk of a lack of diversification, therefore enhancing the role of the Zipf factor. For bubble 2, the Zipf factor is found marginally relevant, suggesting a larger weight of market gains on small firms. We interpret this result as the consequence of the response of the chinese economy to the very large stimulus provided by the Chinese government in the aftermath of the 2008 financial crisis.

Suggested Citation

  • Wanfeng YAN & Ryan WOODARD & Didier SORNETTE, "undated". "Role of diversification risk in financial bubbles," Swiss Finance Institute Research Paper Series 11-26, Swiss Finance Institute.
  • Handle: RePEc:chf:rpseri:rp1126

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    References listed on IDEAS

    1. Adrian, Tobias & Shin, Hyun Song, 2010. "Liquidity and leverage," Journal of Financial Intermediation, Elsevier, vol. 19(3), pages 418-437, July.
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    More about this item


    financial bubbles; rational expectations; positive feedback; factor model; diversification; Chinese market;

    JEL classification:

    • G01 - Financial Economics - - General - - - Financial Crises
    • G17 - Financial Economics - - General Financial Markets - - - Financial Forecasting and Simulation
    • C53 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Forecasting and Prediction Models; Simulation Methods


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