Representative bubbles and deleveraging

Abstract

Purpose

The causes for the formation of a bubble in the collateral market when agents are provided with homogeneous expectations are explored. This bubbly dynamics will define a sufficient condition for deleveraging.

Design/methodology/approach

Theoretical approach with neutral deleveraging.

Findings

Findings of the study are defined sufficient conditions for a behavioral rational bubble's formation in a market of collateral and the subsequent deleveraging. The crowd-in effect of the representative bubble is caused by errors in extrapolating information and thus by representativeness, while the crowd-out effect of deleveraging is set off by reverting to a rational heuristic.

Research limitations/implications

The limit is that it is a homogeneous expectations approach, the implication is that cannot be rational speculation.

Practical implications

Even in a simple model of homogeneous expectations a bubble may arise with serious effect on the demand side: models that detect just rational mispricings cannot account for behavioral components that have financial and real effects.

Originality/value

The paper defines how deleveraging may occur even in case of homogeneous expectations. The latter should not be seen just as a limit but also as a signal of the importance of being aware of behavioral components.

Citation

Strati, F. (2021), "Representative bubbles and deleveraging", Review of Behavioral Finance, Vol. 13 No. 5, pp. 502-521. https://doi.org/10.1108/RBF-03-2020-0053