The Ex Ante Likelihood Of Bubbles

Abstract

The limits of arbitrage explain how a speculative bubble is sustained; they do not explain how likely one is to occur. To do that, you need a theory about the thing that sporadically causes arbitrageur constraints to bind. I propose a first such theory, which is based on social interactions between speculators. The theory says that bubbles should be more likely in assets where increases in past returns make excited speculators relatively more persuasive to their peers. I empirically verify this ex ante prediction about bubble likelihoods and show it is robust to some ex post disagreement about bubble definitions.

Keywords: Limits To Arbitrage, Speculative Bubbles, Social Interactions

JEL Classification: D84, D91, E44, G12