Bubbles and Panics in a Frictionless Market with Heterogeneous Expectations

When investors have differences of opinion about the payoffs of a stock, Harrison and Kreps (1978) demonstrate the existence of a speculative bubble in the stock price, that is, the stock price can exceed the valuation of the most optimistic investor. A crucial condition that supports this result in their model is that investors are not allowed to short sell the stock. This paper demonstrates that speculative bubbles may arise even without the short sales constraint. The paper also demonstrates that asset panics may arise, that is, the stock price may be lower than the valuations of all individual investors. In particular, even if the short sales constraint binds, asset panics can still arise. This result suggests that Miller’s (1977) insight that the short sales constraint causes the stock price to be above the average valuation is not robust in a dynamic framework. In the case of a bubble, our model generalizes the Harrison-Kreps notion of a resale option, namely, investors believe that they can resell the stock later at a higher price. In the case of a panic, our model develops the notion of a waiting option, namely, investors believe that they can purchase the stock later at a lower price.