Working Paper: NBER ID: w1867
Authors: Robert P. Flood; Robert J. Hodrick
Abstract: Evidence of excess volatilities of asset prices compared with those of market fundamentals is often attributed to speculative bubbles. This study examines the sense in which speculative bubbles could in theory lead to excess volatility, hut it demonstrates that some of the variance hounds evidence reported to date precludes bubbles as a reason why asset prices might violate such hounds. The findings must represent some other model misspecffication or market inefficiency. One important misspecification occurs when there searcher incorrectly specifies the time series properties of market fundamentals. A bubble-free example economy characterized by a potential switch in government policies produces paths of asset prices that would appear, to an unwary researcher, to contain bubbles.
Keywords: asset price volatility; speculative bubbles; variance bounds tests
JEL Codes: G12; G14
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Speculative bubbles (E32) | excess volatility of asset prices (G19) |
| anticipated changes in government policies (O24) | asset price paths (G19) |
| model misspecification (C52) | observed relationship between speculative bubbles and asset price volatility (E32) |
| anticipation of policy changes (D84) | asset prices (G19) |
| misinterpretation by researchers (C90) | erroneous conclusions about the presence of bubbles (E32) |
| observed market prices in variance bounds tests (C29) | incorrect conclusions about the presence of bubbles (E32) |
| rejection of null hypotheses in variance bounds tests (C12) | cannot be attributed to rational bubbles (G19) |