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Can We Use Volatility to Diagnose Financial Bubbles? Lessons from 40 Historical Bubbles

127 Pages Posted: 24 Jul 2017  

Didier Sornette

ETH Zürich - Department of Management, Technology, and Economics (D-MTEC); Swiss Finance Institute

Peter Cauwels

ETH Zürich

Georgi Smilyanov

ETH Zurich

Date Written: April 19, 2017

Abstract

We inspect the price volatility before, during, and after financial asset bubbles in order to uncover possible commonalities and check empirically whether volatility might be used as an indicator or an early warning signal of an unsustainable price increase and the associated crash. Some researchers and finance practitioners believe that historical and/or implied volatility increase before a crash, but we do not see this as a consistent behavior. We examine forty well-known bubbles and, using creative graphical representations to capture robustly the transient dynamics of the volatility, find that the dynamics of the volatility would not have been a useful predictor of the subsequent crashes. In approximately two-third of the studied bubbles, the crash follows a period of lower volatility, reminiscent of the idiom of a “lull before the storm”. This paradoxical behavior, from the lenses of traditional asset pricing models, further questions the general relationship between risk and return.

Keywords: gradual portfolio adjustment, international portfolio allocation, predictable excess returns.

JEL Classification: F30, F41, G11, G12

Suggested Citation

Sornette, Didier and Cauwels, Peter and Smilyanov, Georgi, Can We Use Volatility to Diagnose Financial Bubbles? Lessons from 40 Historical Bubbles (April 19, 2017). Swiss Finance Institute Research Paper No. 17-27. Available at SSRN: https://ssrn.com/abstract=3006642

Didier Sornette (Contact Author)

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/

Swiss Finance Institute ( email )

c/o University of Geneve
40, Bd du Pont-d'Arve
1211 Geneva, CH-6900
Switzerland

Peter Cauwels

ETH Zürich ( email )

Zürichbergstrasse 18
8092 Zurich, CH-1015
Switzerland

Georgi Smilyanov

ETH Zurich ( email )

Rämistrasse 101
ZUE F7
Zürich, 8092
Switzerland

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