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Optimism, pessimism and financial bubbles

Bertrand Wigniolle

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In order to explain significant movements in asset prices in recent years, reference is often made to the phenomenon of financial bubbles : an asset price increase that departs radically from its fundamental value, followed by a sudden collapse that reflects the bursting of the bubble. How should we understand such price movements? Economists often have recourse to interpretations based on the irrationality of actors, including flock behaviour, waves of optimism and investor exuberance. Assuming, on the contrary, that economic actors are rational, articles by Jean Tirole in 1985 and Philippie Weil in 1987 showed that it is possible to understand why financial bubbles occur, but also that they obey limiting rules. Several authors then studied whether these rules are empirically verifiable and often concluded that they are not.
In this article, Bertrand Wigniolle revisits the analyses of Triole and Weil, using a certain form of weakened agent rationality, inspired by new theories of behaviour in the face of uncertainty. He uses the rank-dependent expected utility (RDU) model. This model gives a precise sense of the optimism and pessimism of agents in the face of a risky world : an optimistic agent acts as though he overestimates the probability of favourable conditions and underestimates the probability of unfavourable conditions. Can we understand why financial bubbles occur using such a representation of behaviours? Are pessimism and optimism favourable or unfavourable? Wigniolle shows that the influence of optimism and pessimism depend on the rôle played in the agent’s portfolio by the assets among which the financial bubble occurs. If agents invest in these shares in order to cover themselves against a negative shock, then pessimism increases the possibility of a bubble occurring. On the other hand, if the investment is linked to highly speculative behaviour, then optimism favours the emergence of a financial bubble. Finally, it is possible that optimism leads to a phenomenon of “indeterminate equilibrium”, wherein the value of an asset avoids basic economic movements and is guided instead by the agents’ self-fulfilling expectations.
Original title of the article: Optimism, pessimism and financial bubbles
Published in : Journal of Economic Dynamics and Control, Volume 41, Pages 188–208 - Avril 2014
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