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Bubbles and Crashes with Partially Sophisticated Investors

  • Milo Bianchi
  • Philippe Jehiel

We analyze bubbles and crashes in a model in which some investors are partially sophisticated. While the expectations of such investors are endogenously determined in equilibrium, these are based on a coarse understanding of the market dynamics. We highlight how such investors may endogenously switch from euphoria to panic and how this may lead to equilibrium bubbles and crashes even in a purely speculative market in which information is complete and it is commonly understood that the bubble cannot grow forever. We also show how this setting can match stylized empirical facts, and we investigate whether bubbles may last longer when the share of fully rational traders increases.

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Date of creation: 09 Dec 2010
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Handle: RePEc:cla:levarc:122247000000002180
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  1. Peter Temin & Hans-Joachim Voth, 2003. "Riding the South Sea Bubble," Working Papers 91, Barcelona Graduate School of Economics.
  2. Milo Bianchi & Philippe Jehiel, 2008. "Bubbles and crashes with partially sophisticated investors," PSE Working Papers halshs-00586045, HAL.
  3. Dilip Abreu & Markus K. Brunnermeier, 2002. "Bubbles and crashes," LSE Research Online Documents on Economics 24905, London School of Economics and Political Science, LSE Library.
  4. John H. Cochrane, 2002. "Stocks as Money: Convenience Yield and the Tech-Stock Bubble," NBER Working Papers 8987, National Bureau of Economic Research, Inc.
  5. Milgrom, Paul & Stokey, Nancy, 1982. "Information, trade and common knowledge," Journal of Economic Theory, Elsevier, vol. 26(1), pages 17-27, February.
  6. Gerard Gennotte and Hayne Leland., 1989. "Market Liquidity, Hedging and Crashes," Research Program in Finance Working Papers RPF-192, University of California at Berkeley.
  7. Hirshleifer, David, 2001. "Investor Psychology and Asset Pricing," MPRA Paper 5300, University Library of Munich, Germany.
  8. Nagel, Rosemarie, 1995. "Unraveling in Guessing Games: An Experimental Study," American Economic Review, American Economic Association, vol. 85(5), pages 1313-26, December.
  9. Bhattacharya, Utpal & Galpin, Neal & Ray, Rina & Yu, Xiaoyun, 2009. "The Role of the Media in the Internet IPO Bubble," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 44(03), pages 657-682, June.
  10. Veldkamp, Laura L., 2005. "Slow boom, sudden crash," Journal of Economic Theory, Elsevier, vol. 124(2), pages 230-257, October.
  11. Harrison Hong & José Scheinkman & Wei Xiong, 2006. "Asset Float and Speculative Bubbles," Journal of Finance, American Finance Association, vol. 61(3), pages 1073-1117, 06.
  12. Paul C. Tetlock, 2007. "Giving Content to Investor Sentiment: The Role of Media in the Stock Market," Journal of Finance, American Finance Association, vol. 62(3), pages 1139-1168, 06.
  13. Jeheil Phillippe, 1995. "Limited Horizon Forecast in Repeated Alternate Games," Journal of Economic Theory, Elsevier, vol. 67(2), pages 497-519, December.
  14. Hong, Harrison & Stein, Jeremy, 2007. "Disagreement and the Stock Market," Scholarly Articles 2894690, Harvard University Department of Economics.
  15. Biais, Bruno & Bossaerts, Peter, 1998. "Asset Prices and Trading Volume in a Beauty Contest," Review of Economic Studies, Wiley Blackwell, vol. 65(2), pages 307-40, April.
  16. Robin Greenwood & Stefan Nagel, 2008. "Inexperienced Investors and Bubbles," NBER Working Papers 14111, National Bureau of Economic Research, Inc.
  17. Ernan Haruvy & Yaron Lahav & Charles N. Noussair, 2007. "Traders' Expectations in Asset Markets: Experimental Evidence," American Economic Review, American Economic Association, vol. 97(5), pages 1901-1920, December.
  18. David Porter & Vernon Smith, 1994. "Stock market bubbles in the laboratory," Applied Mathematical Finance, Taylor & Francis Journals, vol. 1(2), pages 111-128.
  19. Tirole, Jean, 1982. "On the Possibility of Speculation under Rational Expectations," Econometrica, Econometric Society, vol. 50(5), pages 1163-81, September.
  20. Allen, Franklin & Gale, Douglas, 1994. "Limited Market Participation and Volatility of Asset Prices," American Economic Review, American Economic Association, vol. 84(4), pages 933-55, September.
  21. Colin F. Camerer & Teck-Hua Ho & Juin-Kuan Chong, 2004. "A Cognitive Hierarchy Model of Games," The Quarterly Journal of Economics, MIT Press, vol. 119(3), pages 861-898, August.
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