The Role of Diversification Risk in Financial Bubbles

ETH Risk Center – Working Paper No. ETH-RC-11-003

24 Pages Posted: 21 Dec 2012

See all articles by Wanfeng Yan

Wanfeng Yan

ETH Zurich

Ryan Woodard

ETH Zurich

Didier Sornette

Risks-X, Southern University of Science and Technology (SUSTech); Swiss Finance Institute; ETH Zürich - Department of Management, Technology, and Economics (D-MTEC); Tokyo Institute of Technology

Date Written: July 8, 2011

Abstract

We present an extension of the Johansen-Ledoit-Sornette (JLS) model to include an additional pricing factor called the "Zipf factor'', which describes the diversification risk of the stock market portfolio. Keeping all the dynamical characteristics of a bubble described in the JLS model, the new model provides an additional information about the concentration of stock gains over time. This allows us to understand better the risk diversification and to explain the investors' behavior during the bubble generation. We apply this new model to two famous Chinese stock bubbles, from August 2006 to October 2007 (bubble 1) and from October 2008 to August 2009 (bubble 2). The Zipf factor is found highly significant for bubble 1, corresponding to the fact that valuation gains were more concentrated on the large firms of the Shanghai index. It is likely that the widespread acknowledgement of the 80-20 rule in the chinese media and discussion fora led many investors to discount the risk of a lack of diversification, therefore enhancing the role of the Zipf factor. For bubble 2, the Zipf factor is found marginally relevant, suggesting a larger weight of market gains on small firms. We interpret this result as the consequence of the response of the chinese economy to the very large stimulus provided by the Chinese government in the aftermath of the 2008 financial crisis.

Keywords: financial bubbles, rational expectations, positive feedback, factor model, diversification, Chinese market

JEL Classification: G01, G17, C53

Suggested Citation

Yan, Wanfeng and Woodard, Ryan and Sornette, Didier, The Role of Diversification Risk in Financial Bubbles (July 8, 2011). ETH Risk Center – Working Paper No. ETH-RC-11-003, Available at SSRN: https://ssrn.com/abstract=2191539 or http://dx.doi.org/10.2139/ssrn.2191539

Wanfeng Yan

ETH Zurich ( email )

ETH-Zentrum KPL
Kreuzplatz 5
Zurich, CH-8032
Switzerland

Ryan Woodard

ETH Zurich ( email )

Department of Management, Technology and Economics
Kreuzplatz 5
8032 Zurich, CH-1015
Switzerland
+41 44 632 83 79 (Phone)
+41 44 632 19 14 (Fax)

HOME PAGE: http://www.er.ethz.ch/

Didier Sornette (Contact Author)

Risks-X, Southern University of Science and Technology (SUSTech) ( email )

1088 Xueyuan Avenue
Shenzhen, Guangdong 518055
China

Swiss Finance Institute ( email )

c/o University of Geneva
40, Bd du Pont-d'Arve
CH-1211 Geneva 4
Switzerland

ETH Zürich - Department of Management, Technology, and Economics (D-MTEC) ( email )

Scheuchzerstrasse 7
Zurich, ZURICH CH-8092
Switzerland
41446328917 (Phone)
41446321914 (Fax)

HOME PAGE: http://www.er.ethz.ch/

Tokyo Institute of Technology ( email )

2-12-1 O-okayama, Meguro-ku
Tokyo 152-8550, 52-8552
Japan

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