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G. Bakshi and L. Wu, “Investor Irrationality and the Nasdaq Bubble,” (Paper presented at the meeting of the Western Finance Association, Keystone, Colorado, 22 June 2006).

G. Bakshi and L. Wu, “Investor Irrationality and the Nasdaq Bubble,” (Paper presented at the meeting of the Western Finance Association, Keystone, Colorado, 22 June 2006).

ABSTRACT: This paper investigates whether the rise and fall of the Nasdaq at the turn of the century can be justified by changes in return risk, and whether investors are driven by irrational euphoria with systematic shifts in the market prices of risks (e.g., inexplicable changes in risk aversion and/or subjective probabilities deviating substantially from the objective states of the world). Based on model specification that accommodates fluctuations in both risk levels and market prices of different sources of risks, our analysis provides three new insights. First, the Nasdaq bubble period violated a standard market paradigm that return volatility moves inversely with index valuation; instead,volatility increased with the index. Moreover,inconsistent with rational compensation for increased risk argument, volatility stayed high even after the bubble burst. Second, while the market price of volatility risk is strongly negative traditionally as investors dislike high volatility levels and volatility risk, the market price declined in absolute magnitude and approached zero at the end of 1999, reflecting the market’s strong speculative buying pressure on the Nasdaq, which in turn caused extreme valuations. Third,the options market showed an increasing market price of downside risk that peaked three month prior to the bursting of the bubble, highlighting concerns from the options market on the sustainability of the Nasdaq market valuation.