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National Research University Higher School of EconomicsStudent ThesesExtrapolative Investors with Predictable Behavior and Bubbles

Student
Title
Supervisor
Faculty
Educational Programme
Final Grade
Year of Graduation
Maria Maricheva
Extrapolative Investors with Predictable Behavior and Bubbles
10
2016
This work presents a model that shows how bubbles can emerge in the presence of investors with extrapolative expectations. The motivation for including extrap- olators into an otherwise standard asset pricing setting is substantial evidence of extrapolative behavior among real investors. This fact motivates me to include ex- trapolation as the mechanism of forming investors’ expectations in my work. I adopt a setting similar to the one of Barberis et al.(2015) with two groups of investors: sophisticated investors and extrapolators, where extrapolators’ demand for the risky asset depends on the past changes of the asset price. The key novelty of my model is that I consider sophisticated investors who take into account this specification of extrapolators’ demand when forming their expectations. I analytically characterize and examine the equilibrium prices and find that the a sequence of positive dividend shocks leads to the overvaluation of the asset, the extent of which depends positively on the proportion of extrapolators. I also show that the bubble in my model is as- sociated with high trading volume consistent with empirical features of the bubbles. Finally, I find that the ability of sophisticated investors to predict the extrapolators’ behavior has important implications for the magnitude of the bubble as well as for the lengths of the time period in which the stock price returns to the fundamental level after the shock.

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