ABSTRACT This paper develops a heterogeneous‐investor model to examine how the interactions among rational speculators, irrational investors, and fundamental traders give rise to asset price bubbles. The research reveals that: (1) In the early stage of bubble formation, rational speculators exploit irrational investors' positive‐feedback trading and engage in trade‐inducement strategies, thereby sustaining price deviations from fundamental values; (2) As overvaluation intensifies and prices approach liquidation thresholds, rational speculators shift from speculative to arbitrage‐motivated demand, gradually unwinding their positions or taking contrarian positions. By contrast, irrational investors continue to chase past price increases and extrapolate recent trends, thereby further fueling the expansion of the bubble; (3) Fundamental traders take countercyclical positions and help dampen price deviations as the bubble reaches its later stage; (4) The interaction among different investors provides the key mechanism through which asset price bubbles emerge; (5) Asset price bubbles feature very high trading volume, and that trading volume is positively associated with past asset returns. We provide empirical evidence consistent with several distinctive predictions of the model: (1) During the formation and collapse of the 2015 A‐share market bubble, Chinese mutual funds increased their exposure to high‐valuation stocks during the run‐up and reduced their holdings around the market peak, consistent with a bubble‐riding strategy; (2) This pattern is more consistent with active market timing than with passive exposure to high‐valuation stocks; (3) The 2015 A‐share market bubble was associated with elevated trading volume, and past returns positively predicted subsequent trading volume during the bubble‐building period.
Chen et al. (Thu,) studied this question.
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