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Noisy Rational Bubbles

46 Pages Posted: 22 Sep 2015 Last revised: 31 Mar 2016

Qiusha Peng

Cambridge Endowment for Research in Finance, University of Cambridge

Date Written: March 24, 2016

Abstract

This paper develops a theory of asset price dynamics during bubble-like episodes. In the model, noise trading breaks the winner's curse and leads to overpricing. Over time, investors gradually learn and asset prices tend to fall toward the fundamentals. Importantly, however, investors also update their expectation about the average precision of new information. This mechanism works to drive prices farther away from the intrinsic value. Finally, the model also allows for gradual investor inflows greatly amplifying predicted price movements. Numerical simulations show the model can produce various bubble-like events.

Keywords: Bubbles, Price dynamics, Uncertainty, Investor flows, Noisy rational expectations equilibrium

JEL Classification: D82, G12, G14

Suggested Citation

Peng, Qiusha, Noisy Rational Bubbles (March 24, 2016). Available at SSRN: https://ssrn.com/abstract=2663561 or http://dx.doi.org/10.2139/ssrn.2663561

Qiusha Peng (Contact Author)

Cambridge Endowment for Research in Finance, University of Cambridge ( email )

Trumpington Street
Cambridge, CB2 1AG
United Kingdom

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