Over the years the academic study of bubbles has

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Over the years, the academic study of bubbles has expanded to explore the effects of perverse incentives and of bounded rationality. The new generation of rational models identifies the incentive to herd and the limited liability compensation structure as pervasive problems that encourage professional money managers to invest in bubbles. Another problem contribut- ing to bubbles is that information intermediaries are not paid directly by investors, and their incentives are not always compatible with reporting negative information. And rather than merely trying to answer under what conditions bubbles may exist in asset prices, behavioral models offer new insights for how a bubble may be initiated, under which conditions it would burst, and why arbitrage forces may fail to ensure that prices reflect fundamentals at all times. Moreover, some models offer the explanation for why many bubble episodes are accompa- 2 In addition to feedback traders, institutional restrictions may serve to amplify past price movements. For ex- ample, when it comes to downward prices movements, many institutions are forced to sell their shares of a stock once the firm’s market capitalization falls below the institution’s investible universe. This selling pressure, now unrelated to past news, causes a further price decline. In addition, a lower level of institutional ownership is likely to reduce the stock’s liquidity, making it even less attractive to investors and forcing the price to drop even further. 3 We will use the terms “discount rate” and “required rate of return” interchangeably.
5 nied by high trading volume. The behavioral view of bubbles finds support in experimental studies. The paper proceeds as follows. After a cursory summary of the most famous bubble episodes and a brief description of the classic model, the paper reviews the new generation of rational and behavioral models of bubbles. The paper concludes with how the insights from these new models help understand the evolution of the recent subprime mortgage bubble. II. B UBBLES THROUGH H ISTORY This section provides, in chronological order, a brief overview of famous examples of bubbles observed throughout history. This list is, obviously, incomplete, and for a more complete de- scription of bubbles through history the reader can refer to, for example, Kindleberger ( 2000 ). Perhaps the earliest known example is the tulip bubble in Holland that started in 1634 and burst in February 1637. Amid the general fascination with rare species of tulips among the Dutch, prices on rare tulip bulbs rose, attracting the attention of speculators. Since the supply of rare bulbs was severely limited in the short run, and demand sky-rocketed due to the in- flux of speculators, prices rose rapidly amid heavy trading. At the bubble’s peak, a single tulip bulb sold for an equivalent of $60,000 today.

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