Method in the Madness: Bubbles, Trading, and Incentives

Abstract

A long period of elevated asset valuation raises some fundamental questions. How can assets sustain prices way above their fundamental value for extended periods of time? Why are investors willing to bid up expensive assets? The authors show that for an expensive asset to sustain its valuation, the probability of further price increases must be high. Currency and equity option markets provide evidence. They also show that asset managers might have incentives to go long expensive assets if their prices are more likely to increase. Furthermore, the presence of return-chasing investors could drive prices above their value.

TOPICS: Options, equity portfolio management, currency

Key Findings

• • For an expensive asset to sustain its valuation, the probability of further price increases must be high.

• • Because expensive assets are likely to become more expensive, asset managers might have incentives to go long rather than short them.

• • The presence of momentum and value investors could explain the life cycle of a bubble.