Essay Example: Asset Price Bubbles and Market Crashes

Financial crises, bubbles, and crashes have been a common occurrence in the market from the early days to the present age (Brunnermeier & Oehmke, 2013, p. 3). Typical examples include the Dutch Tulip mania that occurred in the 1930s and the most recent internet bubble of the early 21st century (Abreu & Brunnermeier, 2003, p. 173). Conversely, many scholars who base their arguments on the neoclassical theory, no trade theorems, and efficient market hypothesis oppose the existence of bubbles in the market (Abreu & Brunnermeier, 2003, p. 173; Allen & Gorton, 1993, p. 814). However, all the agents in these models are assumed to be rational. Additionally, the proponents of this view argue that the existence of many rational traders in the market notwithstanding, the presence of many arbitrageurs (who are well-informed) in the same market will guarantee that any potential mispricing due to the behavioral traders is corrected (Abreu & Brunnermeier, 2003, p. 173).

On the other hand, assuming the non-existence of an efficient market model, it is evident that bubbles in the market can survive even in the presence of many rational arbitrageurs especially in the extreme conditions (Abreu & Brunnermeier, 2003, p. 3; Shleifer & Vishny, 1997, p. 54). This is typically possible where there are many traders with animal spirits, utterly optimistic, overconfident, and with psychological biases thus may give rise to momentum trading and trend chasing (Allen & Gorton, 1993, p. 814). Additionally, according to Abreu & Brunnermeier (2003) arbitrageurs have the knowledge of the market and assume it will finally collapse (p. 3). Therefore, most of them will continue watching the bubble as it grows because they will in the meantime generate high returns before it finally crashes (due to the bubbles). However, the only challenge with this situation is the timing of the market so as to exit before the collapse. Hence, the lack of proper synchronization enables the bubble to grow.

Therefore, the existence of asset price bubbles and market crashes does not explicitly show that there are more noise traders than arbitrageurs in the market as the arbitrageurs fail to correct the bubble despite their existence in the market due to their own gains and the technicality in synchronization.

References

Abreu, D., & Brunnermeier, M. K. (2003). Bubbles and crashes. Econometrica, 71(1), 173-204. Available at: https://sci-hub.tw/10.1111/1468-0262.00393

Allen, F., & Gorton, G. (1993). Churning bubbles. The Review of Economic Studies, 60(4), 813-836. Available at: http://finance.wharton.upenn.edu/~allenf/download/Vita/churning.pdf

Brunnermeier M.K., and Oehmke M., (2013), "Bubbles, Financial Crisis, and Systemic Risk", in Handbook of the Economics and Finance Vol 2. https://www0.gsb.columbia.edu/faculty/moehmke/papers/BrunnermeierOehmkeHandbookSystemicRisk.pdf

Brunnermeier, M. K, & Nagel, S. (2004). Hedge funds and the technology bubble. The Journal of Finance, 59(5). Available at: https://scholar.princeton.edu/sites/default/files/hedgefunds_bubble_slides.pdf

Shleifer, A., Vishny R.W. (1997), "The limits of Arbitrage", Journal of Finance, 52, 35-55. Available at: http://citeseerx.ist.psu.edu/viewdoc/download?doi=10.1.1.319.3584&rep=rep1&type=pdf