Question

3. (a) With reference to examples, discuss the characteristics and consequences of financial bubbles.
(b) Discuss the empirical evidence on market under-reaction in the context of weak and semi-strong form efficiency.

Answer 1

Answer-1)

In the financial context, the term "bubble" can be related to a situation when an asset's price exceeds its fundamental value by a huge margin. During financial bubble, there is likely to be a huge inflation of the prices for a financial asset, bearing a tiny relation to the intrinsic asset's value.

The main characteristic of financial bubbles during the "bubble phase" is the suspension of disbelief by majority of participants. There is failure recognition that participants in regular market and other forms of traders are involved in a speculative exercise, which is not supported by previous techniques of valuation. The increases will the most rapid and high just before collapse of the financial bubble. Moreover the bubbles are often identified only in retrospect, after the burst of the bubble.

In majority of the cases, a financial bubble is followed by a spectacular crash in the price of the securities. Furthermore, the damage caused due to the burst of financial bubble will be depending on the involvement of the economic sector/s, and also whether the participation extent is localized or widespread.

For instance, in 1980s the burst of financial bubble in Japan caused a prolonged period of stagnation for the economy of Japanese. However as speculation was mainly confined to Japan, thus the consequences wrought by the bursting of the bubble could not spread much beyond its shores. On contrast the burst of U.S. housing bubble in 2008 lead to destruction on an international basis because majority of financial institutions and banks in the U.S. and Europe were holding toxic subprime mortgage-backed securities which were the hundreds of billions of dollars worth.

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