Financial Bubbles

Question 1

What is a Financial Bubble

Answer 1

a bubble exists when the market rpice of an asset exceeds its intrinsic value for a certain period of time. (price>value)

Question 2

How are bubbles formed

Answer 2

Price is based on the supply and demand of investors.
Investors drive prices above their intrinsic value (feedback loop); resulting in the creation of a bubble.

bubbles bust (mania stops) when the realisation that the price of the stock exceeds its worth

Bubbles can not exist unless they are driven by irrational behaviours (eg. greater fool theory)

Question 3

What is the role of Central Banks

Answer 3

1. manage interest rates
2. control inflation
3. provide liquidity
4. ensure financial stability

Question 4

Why is strong growth hard to maintain

Answer 4

when growth is strong inflation rises = economy grows too fast = demands surpasses supply = c.b tries to intervene by rising interests - stop “good growth” to avoid bad inflation

Question 5

What are the 5 stages of a bubble

Answer 5

1. displacement: investors get infatuated with a product
2. boom: prices rise slowly but gain momentum as more people enter the market
3. euphoria: “greater fool” theory plays out, people try to justify these high prices
4. profit taking: when inverstors begin to sell to generate profit bc they sense the end of a bubble
5. panic: asset prices descend rapidly

Question 6

Are stock prices a reflection of true economic value or can they deviate irrationally forming bubbles

Answer 6

In theory stock prices should reflect intrinsic value of assets IF markets were fully rational… BUT markets are driven by emotional and psychological decisions (eg. easy money/optimism) therefore prices deviate from fundamental value.

Question 7

Solutions to Financial Bubbles

Question 8

What are the consequences of bubbles bursting

Answer 8

1. Prices fall rapidly
2. inverstors panic and sell
3. central banks intervene again
4. ecnonomy may enter recession or financial crisis

Question 9

What causes a bubble

Answer 9

Easy money!!!! – central banks lower interest rates to stimulate borrowings and spending = greater risk = more investements and better returns = can lead to inflation and underestimation of true prices/assets = bubble

Question 10

Greater Fool Theory

Answer 10

people pay more than the fundamental value of an asset bc they are afraid there will be “a greater fool” who will pay for it later - rely on irrationality of others

Question 11

Art References

Answer 11

1. Self-Portrait at an Easel, Rembrandt (1660)
2. Self-Portrait With Saskia, Rembrandt (1635)
3. A Burial at Ornans, Gustave Courbet (1850)
4. Gran Vía, Antonio López (1974-81)
5. Madrid desde Torres Blancas, Antonio López (1976-82)
6. Reflection (Self-Portrait), Lucian Freud (1985)