Research Proposal

Johannes Eigner

Heterogeneous Beliefs and Asset Bubbles

One of the most controversial topics discussed among economists is the existence and predictability of asset bubbles. While some researchers claim that asset bubbles cannot be distinguished from changes in fundamental values (Fama, 1970; Froot and Obstfeld, 1991), others argue that they might be caused by heterogeneous beliefs or speculation on market sentiments (Hommes et al., 2008; Blanchard and Watson, 1983; Shleifer, 2000). After decades of research, there is still no widely accepted theory which explains this market phenomenon (Sheen and Zajac, 2007). Asset bubbles are of special concern to economists because they can lead to severe recessions . Furthermore, persistent mispricing causes inecient allocation of productive resources. To optimize welfare and facilitate growth in an economy it is crucial that relative prices reect intrinsic values.

Literature review
A large body of literature has been devoted to clarify why bubbles occur and whether they are based on rational expectations or not (Camerer, 1989). Blanchard and Watson (1983) investigate the nature and presence of asset bubbles in nancial markets. They conclude that bubbles and market crashes are consistent with rationality when crowd psychology is taken into account. Rationality of behavior and expectations does not imply that the price of an asset must equal its fundamental value. For example, it could be rational to speculate on increasing price deviation if it can be expected, that a group of other traders will do as well. However, the formation of rational expectations on price deviations requires some sort of initial irrationality, such as a group of traders with erroneous beliefs. In contrast, Froot and Obstfeld (1991) argue that excessively volatile prices can be explained exclusively by exogenous changes in fundamental values. They nd that the price component which is unrelated to the present-value model shows strong correlation with dividend growth. They conclude that so called intrinsic bubbles arise from the overreaction of prices to dividend changes. With growing doubts on the predictions from rational expectations models starting in the 1980s (Friedman, 1980; Blanchard and Watson, 1983; Frankel and Froot, 1987; Branch, 2004), a paradigm shift in nancial economics has begun. The ecient market theory does not give a consistent explanation for phenomena such as the excess volatility in prices and the formation of asset bubbles. Furthermore all empirical eorts to link price uctuations to changes in fundamental values have been unsuccessful (Shiller, 2003). 1

Research Proposal

Johannes Eigner

The search for a theory to explain the hidden mechanics on nancial markets has led to a broader social science perspective, including psychology and sociology. Recent empirical ndings in behavioral nance suggest that cognitive biases could be responsible for asset bubbles and other anomalies. Accounting for psychological factors in nancial models is presently one of the most promising paths to understanding investor behavior (Shiller, 2003; Hommes, 2006; Chiarella et al., 2009; Chen et al. 2012). In an experimental study, Hommes et al. (2008) nd that asset bubbles could be caused by price expectations inconsistent with rational expectations. In the experiment, market participants were willing to buy an asset at a price higher than its intrinsic value in hope of speculative prots. De Long et al. (1990) claim that limits to arbitrage could prevent rational speculators from correcting noise in prices. They nd that in the presence of constrained rational agents, market participants may nd it optimal to speculate on a price trend instead of mean reversion.

Previous work
In my masters thesis I simulated a speculative market using a modied version of the overlapping-generations with noise traders model of De Long et al. (1990). To mimic the positive feedback strategy of momentum-traders or chartists, I assumed that the agents are myopic in that they do not use backwards induction to calculate the fundamental value of the risky asset. Instead, they form expectations based on old prices. Bubbles emerge when shocks cause a positive rst dierence in prices. The most interesting result of my work is that even a small share of noise traders in the population are able to absorb arbitrage attempts and trade protably as long as their activity has an impact on prices and fuels further self-fullling expectations. Doubtlessly this result is driven by strong assumptions on rationality and decision making. However it can be regarded as an explanation for the persistence of destabilizing speculation in nancial markets.

Research goals
In my doctoral studies I want to continue my research on the causes of asset bubbles. This includes nding ecient ways to model speculative markets with constrained rational agents whose cognitive biases follow the empirical ndings of behavioral nance. In the next step I want to calibrate the model to t real data and use out of sample forecasts to check its predictive power in explaining excess volatility. Potential data sources are 2

Research Proposal

Johannes Eigner

nancial market data on price developments of stocks with special characteristics. Earlier research in behavioral nance was based e.g. on data from the gold market (Baur and Glover, 2014), stock market indices such as the S&P 500 (Boswijk et al., 2007) and ination rate data (Cornea et al. 2012). The literature on empirical estimation of heterogeneous agents models developed in recent years, but there is still much work to be done (Baur and Glover, 2014). My goal is to determine whether the assumption of heterogeneous agents can give better explanations for market phenomena such as asset bubbles, speculative attacks, or crashes. I want to answer the following research questions: Can long lasting price deviations and asset price bubbles be explained compellingly from the interaction of constrained rational speculators? Is it possible to realistically model speculative behavior in a world of heterogeneous agents and imperfect markets? Under which conditions does destabilizing speculation produce negative externalities such as excess liquidity, capital misallocation and market instability? By assuming heterogeneous beliefs, it has been shown that mispricing can persist on imperfect markets (Barberis and Thaler, 2003). The argument whether improved organization of trade has enhanced price eciency (Fama, 1970), or led to dominance of speculation over fundamental analysis (Keynes, 1936), is still not settled. Optimal levels of liquidity, price-volatility and transaction volume have not yet been found. By understanding the behavior of investors, market failures could be more eciently addressed by policy.

Research Proposal

Johannes Eigner

References
Barberis, N. and Thaler, R. H. (2003). A survey of behavioral nance, in Handbook of the Economics of Finance, Elsevier, pp. 1053-1128. Baur, D.G. and Glover, K.J. (2014). Heterogeneous expectations in the gold market: Specication and estimation, Journal of Economic Dynamics &Control, available online 9 January 2014, ISSN 0165-1889, http://dx.doi.org/10.1016/j.jedc.2014.01.001. Blanchard, O.J., Watson, M.W. (1983). Bubbles, Rational Expectations and Financial Markets, NBER Working Paper No. 0945. Boswijk, H.P., Hommes, C.H., and Manzan, S. (2007). Behavioral heterogeneity in stock prices Journal of Economic Dynamics and Control, vol. 31, pp. 1938-1970. Camerer, C. (1989). Bubbles and Fads in Asset Prices, Journal of Economic Surveys, vol. 3, pp. 3-41. Chen, S.H., Chang, C.L., and Du, Y.R. (2012). Agent-based economic models and econometrics, The Knowledge Engineering Review, vol. 27, pp. 187-219. Chiarella C., Dieci, R., and He, X.-Z. (2007). Heterogeneous expectations and speculative behavior in a dynamic multi-asset framework, Journal of Economic Behavior and Organization, vol. 62, pp. 408-427. Cornea, A., Hommes, C. H., and Massaro, D. (2012). Behavioral heterogeneity in U.S. ination dynamics. CeNDEF working paper, University of Amsterdam. De Long B.J., Shleifer, A., Summers, L.H. and Waldmann, R.J. (1990). Noise trader risk in nancial markets, Journal of Political Economy, vol. 98, pp. 703-738. Fama, E. (1970). Ecient capital markets: a review of theory and empirical work, Journal of Finance, vol. 25, pp. 383-417. Frankel, J.A. and Froot, K.A. (1987). Using survey data to test standard propositions regarding exchange rate expectations, American Economic Review, vol. 77(1), pp. 133153. Hommes, C. H. (2006). Heterogeneous agent models in economics and nance, in: Tesfatsion, L. and Judd, K. (eds.), Agent-based Compuational Economics, vol. 2 of Handbook of Computational Economics, North-Holland, pp. 1109-1186. Hommes, C., Sonnemans, J., Tuinstra, J., van de Velden, H. (2008). Expectations and bubbles in asset pricing experiments, Journal of Economic Behaviour & Organization, vol. 67, pp. 116-133. 4

Research Proposal

Johannes Eigner

Keynes, J. M. (1936). The General Theory of Employment, Interest and Money, London: MacMillan. Sheen, S.L., Zajac, E.J. (2007). The Institutional Nature of Price Bubbles, SSRN Working Paper Series. Shiller, R.J. (2003). From Ecient Markets Theory to Behavioral Finance, Journal of Economic Perspectives, vol. 17, pp. 83-104. Shleifer, A. (2000). Review of: Inecient Markets: An Introduction to Behavioral Finance, Oxford: Oxford University Press.