On Origins of Bubbles

Journal of Risk & Control 4(1) (2017) 1-30

26 Pages Posted: 29 Aug 2016 Last revised: 31 Jul 2017

See all articles by Zura Kakushadze

Zura Kakushadze

Quantigic Solutions LLC; Free University of Tbilisi

Date Written: August 27, 2016

Abstract

We discuss – in what is intended to be a pedagogical fashion – a criterion, which is a lower bound on a certain ratio, for when a stock (or a similar instrument) is not a good investment in the long term, which can happen even if the expected return is positive. The root cause is that prices are positive and have skewed, long-tailed distributions, which coupled with volatility results in a long-run asymmetry. This relates to bubbles in stock prices, which we discuss using a simple binomial tree model, without resorting to the stochastic calculus machinery. We illustrate empirical properties of the aforesaid ratio. Log of market cap and sectors appear to be relevant explanatory variables for this ratio, while price-to-book ratio (or its log) is not. We also discuss a short-term effect of volatility, to wit, the analog of Heisenberg’s uncertainty principle in finance and a simple derivation thereof using a binary tree.

Keywords: Bubble, Skewed Distribution, Stock Price, Volatility, Return, Dividends, Buybacks, Binomial Tree, Brownian Motion, Uncertainty Principle, Market Cap, Price-To-Book, Sectors, Time Ordering

JEL Classification: G00

Suggested Citation

Kakushadze, Zura, On Origins of Bubbles (August 27, 2016). Journal of Risk & Control 4(1) (2017) 1-30, Available at SSRN: https://ssrn.com/abstract=2830773 or http://dx.doi.org/10.2139/ssrn.2830773

Zura Kakushadze (Contact Author)

Quantigic Solutions LLC ( email )

680 E Main St #543
Stamford, CT 06901
United States
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HOME PAGE: http://www.linkedin.com/in/zurakakushadze

Free University of Tbilisi ( email )

Business School and School of Physics
240, David Agmashenebeli Alley
Tbilisi, 0159
Georgia

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