Non-equivalent beliefs and subjective bubbles

Speaker(s): 
Martin Larsson (Swiss Finance Institute)
Date: 
Thursday, May 8, 2014 - 4:00pm
Location: 
TU Berlin, R. MA 041, Straße des 17. Juni 136, 10623 Berlin

In a complete market, the price bubble on a traded asset is defined as the difference between its market price and the smallest amount needed to replicate the associated cash flows. It is well understood that the presence of nonzero bubbles is consistent with absence of arbitrage, even when portfolio restrictions are absent. However, reconciling price bubbles with economic equilibrium has so far required portfolio constraints on some or all agents. This paper develops a simple equilibrium model without portfolio constraints (other than a standard solvency condition), but with a beliefs structure exhibiting an extreme degree of heterogeneity: agents do not even agree about zero probability events. Equilibrium still exists in this setting, and the strong heterogeneity naturally leads to price bubbles. The bubbles are subjective in the sense that they are perceived by some but not necessarily all agents.