The Ex Ante Likelihood of Bubbles
Management Science · 2023 · Volume 69 · Issue 2
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 that it is robust to some ex post disagreement about bubble definitions. This paper was accepted by Victoria Ivashina, finance. Supplemental Material: The data files and online appendix are available at https://doi.org/10.1287/mnsc.2022.4351 .
Keywords
limits to arbitrage, speculative bubbles, social interactions
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