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On Origins of Bubbles

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  • Zura Kakushadze

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.

Suggested Citation

  • Zura Kakushadze, 2016. "On Origins of Bubbles," Papers 1610.03769, arXiv.org, revised Jul 2017.
    • Handle: RePEc:arx:papers:1610.03769
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    References listed on IDEAS

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    1. Zura Kakushadze, 2015. "On Origins of Alpha," Papers 1511.01395, arXiv.org.
    2. Vladimir Soloviev & Vladimir Saptsin, 2011. "Heisenberg uncertainty principle and economic analogues of basic physical quantities," Papers 1111.5289, arXiv.org.
    3. Didier SORNETTE & Peter CAUWELS, 2014. "Financial Bubbles: Mechanisms and Diagnostics," Swiss Finance Institute Research Paper Series 14-28, Swiss Finance Institute.
    4. Zura Kakushadze, 2015. "Path integral and asset pricing," Quantitative Finance, Taylor & Francis Journals, vol. 15(11), pages 1759-1771, November.
    5. Didier Sornette & Peter Cauwels, 2014. "Financial bubbles: mechanisms and diagnostics," Papers 1404.2140, arXiv.org.
    6. Michael R. Powers, 2010. "Uncertainty principles in risk finance," Journal of Risk Finance, Emerald Group Publishing, vol. 11(3), pages 245-248, May.
    7. Biane, Philippe, 2010. "Itô's stochastic calculus and Heisenberg commutation relations," Stochastic Processes and their Applications, Elsevier, vol. 120(5), pages 698-720, May.
    8. Merton H. Miller & Franco Modigliani, 1961. "Dividend Policy, Growth, and the Valuation of Shares," The Journal of Business, University of Chicago Press, vol. 34, pages 411-411.
    9. Black, Fischer & Scholes, Myron S, 1973. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 637-654, May-June.
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    Cited by:

    1. Zura Kakushadze, 2019. "Healthy. . .Distress. . . Default," Journal of Risk & Control, Risk Market Journals, vol. 6(1), pages 113-119.
    2. Zura Kakushadze, 2019. "Healthy... Distress... Default," Papers 1910.08531, arXiv.org, revised Oct 2019.
    3. Zura Kakushadze & Willie Yu, 2017. "Notes on Fano Ratio and Portfolio Optimization," Papers 1711.10640, arXiv.org, revised Apr 2018.

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