On the Inception of Rational Bubbles in Stock Prices
Behzad T. Diba
Herschel I. Grossman
This paper analyzes the theoretical possibility of rational
bubbles in stock prices in a model in which stockholders have
infinite planning horizons and in which free disposal of equity
rules out the existence of negative rational bubbles. The
analysis shows that in this framework if a positive rational
bubble exists, then it started on the first date of trading of
the stock. Thus, the existence of a rational bubble at any date
would imply that the stock has been overvalued relative to market
fundamentals since the first date of trading and that prior to
the first date of trading potential stockholders who anticipated
the initial pricing of the stock expected that the stock would be
overvalued relative to market fundamentals. The analysis also
shows that any rational bubble will eventually burst and will not
restart. Thus, even if a positive rational bubble exists,
stockholders know that after a random, but almost surely finite,
date the stock price will conform to market fundamentals forever.
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