Diagnostics of Rational Expectation Financial Bubbles with Stochastic Mean-Reverting Termination Times

TL;DR

This paper introduces two rational expectation models for transient financial bubbles with stochastic mean-reverting termination times, providing analytical solutions and tests to diagnose and forecast bubble terminations in financial markets.

Contribution

The paper develops explicit analytical models and novel diagnostic tests for financial bubbles, accounting for heterogeneous agents and stochastic bubble durations.

Findings

Models successfully diagnose bubbles in historical data

Operational procedures forecast bubble end times

Empirical tests suggest feasibility of early warning signals

Abstract

We propose two rational expectation models of transient financial bubbles with heterogeneous arbitrageurs and positive feedbacks leading to self-reinforcing transient stochastic faster-than-exponential price dynamics. As a result of the nonlinear feedbacks, the termination of a bubble is found to be characterized by a finite-time singularity in the bubble price formation process ending at some potential critical time $\tilde{t}_c$, which follows a mean-reversing stationary dynamics. Because of the heterogeneity of the rational agents' expectations, there is a synchronization problem for the optimal exit times determined by these arbitrageurs, which leads to the survival of the bubble almost all the way to its theoretical end time. The explicit exact analytical solutions of the two models provide nonlinear transformations which allow us to develop novel tests for the presence of bubbles in financial time series. Avoiding the difficult problem of parameter estimation of the stochastic differential equation describing the price dynamics, the derived operational procedures allow us to diagnose bubbles that are in the making and to forecast their termination time. The tests performed on three financial markets, the US S&P500 index from 1 February 1980 to 31 October 2008, the US NASDAQ composite index from 1 January 1980 to 31 July 2008 and the Hong Kong Hang Seng index from 1 December 1986 to 30 November 2008, suggest the feasibility of advance bubble warning.