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Seminar: by Christopher Wegener: "Riding the bubble or hedging the burst?"

Monday 6 March 2023Add to my calendar

Financial risk management matters, especially during crash phases following upon periods of exuberance. Bubbles, as a leading example for such behavior, are widely studied and empirically well established in the literature. However, the impact of financial bubbles, characterized by explosive price increases followed by sharp declines, on risk management has not been fully explored. We theoretically study the terminal wealth distributions of agents with risk-limited investments in a time-discrete stochastic bubble framework with random crashes. Our model allows for flexible modeling of both abrupt and smooth collapses. Agents might either ride the bubble or hedge against its burst (while ignoring the bubble is a special case of the hedging strategy). To compare the two distinct strategies, we apply a novel notion of stochastic dominance (SD) bridging first- and second-order SD. We thus establish conditions for the two mutually exclusive situations of (i) concave (risk-avoiding) SD of the terminal wealth distribution under hedging overriding the bubble and (ii) convex (risk-loving) SD of the terminal wealth distribution under riding over hedging. In an empirical application to 152 historic explosive episodes in 24 major stock markets, we find evidence that there are risk-averse investors preferring the riding over the hedging strategy, provided that the agents can liquidate their collapsing asset in a short period of time (i.e., within one or two trading days).