Working Paper: NBER ID: w1990
Authors: Behzad Diba; Herschel I. Grossman
Abstract: This paper analyzes the theoretical possibility of rational \nbubbles in stock prices in a model in which stockholders have \ninfinite planning horizons and in which free disposal of equity \nrules out the existence of negative rational bubbles. The \nanalysis shows that in this framework if a positive rational \nbubble exists, then it started on the first date of trading of \nthe stock. Thus, the existence of a rational bubble at any date \nwould imply that the stock has been overvalued relative to market \nfundamentals since the first date of trading and that prior to \nthe first date of trading potential stockholders who anticipated \nthe initial pricing of the stock expected that the stock would be \novervalued relative to market fundamentals. The analysis also \nshows that any rational bubble will eventually burst and will not \nrestart. Thus, even if a positive rational bubble exists, \nstockholders know that after a random, but almost surely finite, \ndate the stock price will conform to market fundamentals forever.
Keywords: Rational Bubbles; Stock Prices; Market Fundamentals
JEL Codes: D84; E44; G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Inception of trading (N21) | Existence of a positive rational bubble (C62) |
| Existence of a positive rational bubble (C62) | Overvaluation of stock relative to market fundamentals (G19) |
| Bursting of a rational bubble (E32) | Return to market fundamentals (G18) |
| Initial pricing expectations of stockholders (G13) | Overvaluation of stock (G32) |