Diagnostic bubbles

Bordalo, Pedro, Gennaioli, Nicola, Kwon, Spencer Yongwook and Shleifer, Andrei (2018) Diagnostic bubbles. UNSPECIFIED.

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Abstract

We introduce diagnostic expectations into a standard setting of price formation in which investors learn about the fundamental value of an asset and trade it. We study the interaction of diagnostic
expectations with two well-known mechanisms: learning from prices and speculation (buying for resale). With diagnostic (but not with rational) expectations, these mechanisms lead to price paths
exhibiting three phases: initial underreaction, followed by overshooting (the bubble), and finally a crash. With learning from prices, the model generates price extrapolation as a byproduct of fast moving beliefs about fundamentals, which lasts only as the bubble builds up. When investors speculate, even mild diagnostic distortions generate substantial bubbles.

Item Type: Other Working Paper
Keywords: finance
Subject(s): Finance
Date Deposited: 08 Jan 2019 15:28
Last Modified: 08 Jan 2019 15:28
Funders: Gennaioli thanks the European Research Council (GA 647782) for financial support
URI: http://eureka.sbs.ox.ac.uk/id/eprint/7219

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