Detection of financial bubbles: In the context of emerging markets

Abstract

Financial bubbles have always been present irrespective of whether the stock markets existed or not and often have been a cause of great distress. Financial bubbles, as coined Markus Brunnermaier at Princeton, typically occur when price of an asset dramatically increases, followed by a sharp downfall. The price usually exceeds the fundamental value of the asset by a significant amount, which cannot be sustained for a long time. A bubble is detected usually at a point when the prices have already begun to fall and a massive panic has gripped the market. At this point, detection of a financial bubble offers no real benefit. However, if they could be predicted during the price rise step, they could be prevented, which is where the real value lies. The oldest, well document event of occurrence of a bubble is the “Tulip Mania” of the 17th century. It all began with the introduction of the tulip flower in Vienna in 1554 where they gained sudden fame due to its unique saturated petal colours which no other flower of Europe exhibited at that time. This led to the flower being seen as an item of luxury. This was further aggravated by influence of a non-fatal virus mosaic, which enhanced the colours of its petals. Soon the prices of the bubbles rose, because of which many began to trade these tulip bulbs. People began to hoard these bulbs with an expectation to either grow them later and sell them at a much higher price. As the supply fell and demand rose, the prices sky-rocketed. The people saw the rise in prices as an opportunity to make good profits by riding the wave. Many traded their lands, houses and liquidated all their assets to get a few tulip bulbs. Obviously the tulips were in the phase of a bubble as prices did not reflect the true value of the underlying. As the bubble reached its peak, many began to sell due to the fear of a possible decline in prices. Since the prudent buyers were not ready to buy (due to the similar reason) the prices fell sharply. At the end of it all, the tulip mania left several people in very poor financial conditions with nothing else but a few tulip bulbs worth almost nothing. The Tulip Mania teaches us an important lesson as to how unjustified exuberance leads to the development of a bubble in the financial markets. Another such example would be the dotcom bubble of the late 1990s. The dot com bubble occurred because of sudden rise in the equity prices of the internet based companies as investors continued to invest in the new technology. However, this was just a fad that arose due to the introduction of a new innovative means of communication, not backed by rational analysis. As the investment capital shrunk, it soon became clear that only a few companies like Intel, Cisco were driving this rise in equity prices while the rest were just riding the publicity. The true value of majority of the startups was revealed and the markets quickly collapsed, causing severe financial losses to many. The third most prominent example of a financial bubble was housing bubble of 2008 leading to a global crisis. This case also exhibited similar irrational excitement in the market causing the housing prices to crash and causing several banks and other debt holders to incur losses. It is fairly evident from these cases that financial bubbles occur as the prices of an asset rise with no clear indication of rise in the value of the underlying.