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Bubbles and Crashes with Partially Sophisticated Investors

  • Bianchi, Milo
  • Jehiel, Philippe

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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Paper provided by Paris Dauphine University in its series Economics Papers from University Paris Dauphine with number 123456789/5361.

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Date of creation: 2010
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Publication status: Published in PSE Working Papers, 2010
Handle: RePEc:dau:papers:123456789/5361
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  1. Milgrom, Paul & Stokey, Nancy, 1982. "Information, trade and common knowledge," Journal of Economic Theory, Elsevier, vol. 26(1), pages 17-27, February.
  2. Temin, Peter & Voth, Hans-Joachim, 2004. "Riding the South Sea Bubble," CEPR Discussion Papers 4221, C.E.P.R. Discussion Papers.
  3. Tirole, Jean, 1982. "On the Possibility of Speculation under Rational Expectations," Econometrica, Econometric Society, vol. 50(5), pages 1163-81, September.
  4. David Hirshleifer, 2001. "Investor Psychology and Asset Pricing," Journal of Finance, American Finance Association, vol. 56(4), pages 1533-1597, 08.
  5. 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.
  6. Veldkamp, Laura L., 2005. "Slow boom, sudden crash," Journal of Economic Theory, Elsevier, vol. 124(2), pages 230-257, October.
  7. Dilip Abreu & Markus K. Brunnermeier, 2003. "Bubbles and Crashes," Econometrica, Econometric Society, vol. 71(1), pages 173-204, January.
  8. Milo Bianchi & Philippe Jehiel, 2008. "Bubbles and crashes with partially sophisticated investors," PSE Working Papers halshs-00586045, HAL.
  9. Gerard Gennotte and Hayne Leland., 1989. "Market Liquidity, Hedging and Crashes," Research Program in Finance Working Papers RPF-192, University of California at Berkeley.
  10. David Porter & Vernon Smith, 1994. "Stock market bubbles in the laboratory," Applied Mathematical Finance, Taylor & Francis Journals, vol. 1(2), pages 111-128.
  11. Robin Greenwood & Stefan Nagel, 2008. "Inexperienced Investors and Bubbles," NBER Working Papers 14111, National Bureau of Economic Research, Inc.
  12. Harrison Hong & Jose Scheinkman & Wei Xiong, 2005. "Asset Float and Speculative Bubbles," Levine's Bibliography 122247000000000861, UCLA Department of Economics.
  13. 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.
  14. 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.
  15. Jeheil Phillippe, 1995. "Limited Horizon Forecast in Repeated Alternate Games," Journal of Economic Theory, Elsevier, vol. 67(2), pages 497-519, December.
  16. 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.
  17. John H. Cochrane, 2002. "Stocks as Money: Convenience Yield and the Tech-Stock Bubble," NBER Working Papers 8987, National Bureau of Economic Research, Inc.
  18. 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.
  19. Harrison Hong & Jeremy C. Stein, 2007. "Disagreement and the Stock Market," Journal of Economic Perspectives, American Economic Association, vol. 21(2), pages 109-128, Spring.
  20. Nagel, Rosemarie, 1995. "Unraveling in Guessing Games: An Experimental Study," American Economic Review, American Economic Association, vol. 85(5), pages 1313-26, December.
  21. 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.
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