The formula of buble

Posted by: admin 3 months, 1 week ago

(Comments)

An **asset bubble** doesn't have a single, universally accepted formula, but it can be understood through a combination of economic models and indicators that show when asset prices deviate significantly from their intrinsic or fundamental values. Typically, asset bubbles occur when the prices of financial assets, such as stocks, real estate, or commodities, rise rapidly and unsustainably due to speculative demand, often detached from the underlying economic fundamentals.

While there's no single formula that defines an asset bubble, several economic models and concepts can help explain and identify bubble behavior. Below are key models and methods that relate to asset bubbles:

### 1. **Fundamental Value vs. Market Price**:
At the heart of an asset bubble is the difference between an asset's **market price** and its **fundamental value**. The fundamental value of an asset can be approximated using present value models, where the price of an asset reflects the expected future cash flows (like dividends for stocks or rents for real estate), discounted to the present.

The formula for the **fundamental price** of an asset, using the **present value model**, is:

\[
P = \sum_{t=1}^{\infty} \frac{CF_t}{(1 + r)^t}
\]

Where:
- **\( P \)**: Fundamental price of the asset.
- **\( CF_t \)**: Expected cash flows in period \( t \) (such as dividends, rents, etc.).
- **\( r \)**: Discount rate or required rate of return.

An **asset bubble** can be identified when the **market price** \( P_{market} \) significantly exceeds this **fundamental price** \( P \). That is:

\[
\text{Bubble} = P_{market} - P_{fundamental}
\]

If this difference becomes large and grows over time, it can be a sign of an asset bubble.

### 2. **Exponential Growth of Prices**:
In many bubbles, asset prices follow an **exponential growth pattern**, where prices rise at an accelerating rate due to speculative buying. The exponential price growth can be modeled as:

\[
P_t = P_0 \cdot e^{\alpha t}
\]

Where:
- **\( P_t \)**: Asset price at time \( t \).
- **\( P_0 \)**: Initial price of the asset.
- **\( \alpha \)**: Growth rate of the asset price.
- **\( t \)**: Time.

In a bubble, **\( \alpha \)** is excessively high because of speculative behavior, and prices are driven by the expectation of future price increases rather than fundamental values. This kind of price growth is unsustainable, and eventually, the bubble bursts when market participants realize that prices have become disconnected from reality.

### 3. **Price-to-Earnings (P/E) Ratio**:
A common way to detect bubbles in the stock market is by looking at the **Price-to-Earnings (P/E) ratio**. The P/E ratio compares the price of a stock to its earnings. In a bubble, the P/E ratio tends to become abnormally high as asset prices rise without a corresponding increase in earnings.

The formula for the **P/E ratio** is:

\[
\text{P/E Ratio} = \frac{P}{E}
\]

Where:
- **\( P \)**: Price of the asset (stock).
- **\( E \)**: Earnings (or profits) of the asset.

A **high P/E ratio** indicates that investors are willing to pay a large amount for each dollar of earnings, which can signal speculative behavior. Historically high P/E ratios often precede asset bubbles.

### 4. **Supply and Demand Dynamics**:
In an asset bubble, demand for the asset exceeds its **fundamental supply**, often due to **speculative demand**. As more people buy into the market expecting prices to keep rising, the demand pushes prices up further, creating a positive feedback loop. This dynamic can be modeled using simple supply and demand principles.

If **demand** is given by:

\[
Q_d = a - bP
\]

And **supply** is given by:

\[
Q_s = c + dP
\]

Where:
- **\( P \)**: Price of the asset.
- **\( Q_d \)**: Quantity demanded.
- **\( Q_s \)**: Quantity supplied.
- **\( a, b, c, d \)**: Constants that represent demand and supply elasticity.

An asset bubble can be characterized by an increase in speculative demand that causes a deviation between supply and demand, leading to rapid price increases. When speculative demand dries up, the market often crashes, and the bubble bursts.

### 5. **Tobin's Q Ratio**:
**Tobin's Q ratio** compares the market value of an asset or company to the replacement cost of its assets. If **Tobin's Q** is greater than 1, it suggests that the market is overvaluing the asset relative to its replacement cost, which can be a sign of a bubble.

The formula for Tobin's Q is:

\[
Q = \frac{\text{Market Value of Assets}}{\text{Replacement Cost of Assets}}
\]

- If **\( Q > 1 \)**, it suggests overvaluation (possible bubble).
- If **\( Q < 1 \)**, it suggests undervaluation.

### 6. **Behavioral Finance Models**:
Asset bubbles are often fueled by **irrational behavior** and **herd mentality**, where investors buy an asset simply because others are buying, expecting prices to continue rising. Behavioral finance models, such as those based on **herd behavior** and **greater fool theory**, can help explain why bubbles form.

#### Herd Behavior:
Investors might follow the crowd rather than relying on their own analysis. This behavior can be modeled as:

\[
D_t = \rho D_{t-1} + \varepsilon_t
\]

Where:
- **\( D_t \)**: Decision to invest in period \( t \).
- **\( \rho \)**: Coefficient representing the tendency to follow others.
- **\( D_{t-1} \)**: Previous period's decisions.
- **\( \varepsilon_t \)**: Random noise.

When **\( \rho \)** is high, it means investors are heavily influenced by others’ behavior, leading to herd behavior that fuels the bubble.

### 7. **Feedback Loop Models**:
Asset bubbles are often driven by **positive feedback loops** where rising prices fuel further demand, which in turn pushes prices higher. This process continues until the bubble bursts.

A simple feedback loop can be modeled as:

\[
P_t = P_{t-1} + \alpha (P_{t-1} - P_{t-2})
\]

Where:
- **\( P_t \)**: Price at time \( t \).
- **\( P_{t-1} \)**: Price in the previous period.
- **\( P_{t-2} \)**: Price two periods ago.
- **\( \alpha \)**: Sensitivity to the previous price changes.

In a bubble, **\( \alpha \)** becomes large, and the price increases at an accelerating rate, leading to an unsustainable growth pattern that eventually collapses.

### Summary:
There isn't a single, definitive formula for an asset bubble, but several economic models and indicators help to explain and detect bubbles. These include:

1. **Fundamental value vs. market price**:
\[
\text{Bubble} = P_{market} - P_{fundamental}
\]

2. **Exponential price growth**:
\[
P_t = P_0 \cdot e^{\alpha t}
\]

3. **Price-to-Earnings (P/E) ratio**:
\[
\text{P/E Ratio} = \frac{P}{E}
\]

4. **Tobin's Q ratio**:
\[
Q = \frac{\text{Market Value of Assets}}{\text{Replacement Cost of Assets}}
\]

5. **Supply and demand dynamics** that create deviations between asset price and underlying fundamentals.

6. **Behavioral finance** models explain bubbles as the result of irrational behavior and speculation.

Asset bubbles occur when prices rise rapidly, driven by speculation and positive feedback loops, and eventually collapse when the disconnect from fundamentals becomes unsustainable.

• ← Do you know that every 1 dollar spending will affect the output by 5 dollar
• How the Yen currency appreciation affect carry trade →