Bubbles and Crashes

These notes consider Abreu and Brunnermeier’s (2003) paper on the failure of rational arbitrage in asset markets. Recall that the “no-trade” theorem states that speculative bubbles cannot exist in a world with only rational traders even if there is asymmetric information, so long as these traders share a common prior. Believers in the efficient market hypothesis argue that even if there are also behavioral or boundedly rational traders in the market, the presence of rational arbitrageurs will still push asset prices to fundamental values. Various models have been put forward as to why this might not be the case (e.g. Delong et al. 1990; Shleifer and Vishny, 1997). The idea of AB’s paper is that even when rational arbitrageurs are aware of mispricing, a lack of common knowledge may prevent them from coordinating their attacks on a buble. As a result, persistent mispricing may occur even in the presence of rational traders.