Based on the simple behavioral model by shiller(1989) and the rational valuation formula, explain how rational traders may cause excess volatility and explain using the formula, how bubbles can occur when noise traders are present

Based on the simple behavioral model by shiller(1989) and the rational valuation formula, explain how rational traders may cause excess volatility and explain using the formula, how bubbles can occur when noise traders are present

 

answer:

The value an investor is prepared to pay, for a stock is dependant on the price thhe investor thinks he can get in the futue. The price the investor expects in the future may contain an explosive bubble.

Even if investors are perfectly rational, there can be excess volatility, due to market psychology. Example Bad news about financial data of an industry leader, causes the prices of other companies in the same industryy fall significantly. similarly rise in prices due to good news. This increases the volatility in the market.

Therefore even if investors are rational, there can be a divergence between stock prices and their fundamental values.

we show that the market price = its fundamental value + bubble and stock is still held by rational investors and no excess profits can be made.

Assuming investors are risk neutral and have rational expectations. further investors require a constant rate of return on the

 

 

Another mathematical expression for Pt is

 

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