Question

 

1) What are the problems associated with Bitcoin valuation, concerning the methods we discussed in valuation of stocks?

2) What is a price bubble? How common are bubbles in the markets? What do you think about the possibility of forming a bubble in an efficient market? That is, would we observe bubbles if the markets are efficient? Why?

Answer 1

1) Bitcoin is a kind of digital currency that is traded in digital platforms. The value of digital currency is due to the fact that the investors beleive that the bitcoin possesses value. The similar concept is used in the valuation of stocks as well. The value of stock exists because investors believe that the stock has value. But there is a point of difference between stocks and bitcoins i.e. there exists an underlying asset for stocks but there is no underlying asset for bitcoins. This is the major problem in the valuation of bitcoins when compared to the valuation of stocks.

2) Price bubble is the situation when the price of the asset increases continuously and at a sustained rate. The valuation increases so sharply that they defy the fundamentals of valuation and finally lead to a sudden fall. This is also called the bursting of the bubble.

Bubbles are quite common in the market. It has been seen that whenever the market comes across some new idea or financial instrument then there is a tendency to form a bubble. For example there was the real estate bubble, IT bubble etc. They are formed mostly due to the curiosity and the interest of people in a new financial instrument and the risk taking nature to invest in new areas or instruments.

No, there would not be bubbles in efficient markets. The reason is that the efficient market hypothesis states that the markets are perfect and there is no information that is not known to the participants in the market. If this is the case then the bubble will not be formed at all. A bubble is formed when the asset value is beyond its actual price of underlying asset.