Bubbles

What causes bubbles? Bubbles are due to high volumes of inflated asset prices, caused by valuations based on investor expectations. These over-priced stocks have strayed from their intrinsic values and inevitably will be subject to significant price reversals at some point in the future, i.e. the bubble will burst. 

There have been many different explanations for bubbles forming in the marketplace. The main reasoning is irrationality in investor behaviour and mispricing or stocks. 

Allen and Gale (2000) suggest bubbles are an agency problem in the banking sector, the result of risk shifting between investors and banks (borrowing form banks to invest in risky stocks). They characterise bubbles as a 3 stage process;

1)      Financial Liberalization resulting in expansion of credit and accompanied by an increase in the price of market assets such as real estate or stocks. These price rises continue for a set period of time. This is how the bubble inflates.

2)      The bubble bursts and asset prices collapse suddenly, often in the space of a few days, leaving investors not a lot of time to react.

3)      Firms and agents who have borrowed to finance the purchase of inflated assets lose out, often defaulting on their loans. The volume of these defaults has a rippling effect through banks often leading to financial crises.

*Allen, F. & Gale, D. 2000, "Bubbles and crises", The Economic Journal, vol. 110, no. 460, pp. 236-255