Question

Short essay answer please

1- what roles do herding and leverage play in creating a financial bubble?

Answer 1

Leverage/Liquidity: In every bubble, there is some form of financial innovation that broadly increases both leverage and liquidity. This is critical, because the expansion of leverage not only provides massive liquidity to fund the expansion of the bubble, but the leverage also sets up the covenants that inevitably unwind when the bubble turns aggressively to the downside. In some ways, it’s also inevitable. When a large number of people believe they’ve found a sure thing, logic dictates they should borrow cheap money to maximize their returns. In fact, the belief it may be a bubble can make them even greedier to lever up their investment so they can “cash out” the most before the inevitable break.

Herding and Investment Bubbles
An investment bubble occurs when exuberant market behavior drives a rapid escalation in the price of an asset above and beyond its intrinsic value. The bubble continues to inflate until the asset price reaches a level beyond fundamental and economical rationality. At this stage in a bubble’s existence, further increases in the cost of the asset often are contingent purely on investors continuing to buy in at the highest price. When investors are no longer willing to buy at that price level, the bubble begins to collapse. In speculative markets, the burst can incite far-reaching corollary effects.
Some bubbles occur organically, driven by investors who are overcome with optimism about a security’s price increase and a fear of being left behind as others realize significant gains. Speculators are drawn to invest, and thus cause the security price and trading volume to climb even higher. The irrational exuberance over dotcom stocks in the late 1990s was driven by cheap money, easy capital, market overconfidence and over-speculation. It did not matter to investors that many dotcoms were generating no revenue, much less profits. The herding instincts of investors made them anxious to pursue the next initial public offering (IPO) while completely overlooking traditional fundamentals of investing. Just as the market peaked, investment capital began to dry up, which led to the bursting of the bubble and steep investment losses.