From the CFA Institute's Enterprising Investor blog, June 11:
It is widely understood that psychological factors such as perceptions and herd mentality can significantly influence stock market dynamics and precipitate speculative bubbles and abrupt market corrections. Less appreciated is the fact that the foreign exchange (FX) market is equally susceptible to such risks and perhaps more so in the context of geopolitical events.
The FX market — an over-the-counter marketplace that sets exchange rates for currencies worldwide — is the largest market globally in terms of trading volume. We’re going to look at bubbles in the FX market through the lens of Robert Shiller and Didier Sornette.
A notable example of an FX market bubble and crash is the case of the Icelandic króna during the early 2000s. The króna appreciated significantly following the deregulation of Iceland’s financial sector in 2001, which allowed financial institutions to expand and facilitated greater foreign investment. This financial-sector expansion, combined with Iceland’s high interest rates, attracted considearble speculative investment as herd mentality settled in.
In early 2007, The Economist ranked the Icelandic króna as the most overvalued currency based on its Big Mac Index. The bubble burst during the global financial crisis of 2008, resulting in a severe depreciation of the króna and a dramatic economic collapse for Iceland.
Shiller Challenges Neoclassical Models
When speaking about price bubbles in any asset class, it is essential to start with Shiller’s theories and then move onto Sornette’s models. Shiller’s insights into financial market dynamics challenge traditional neoclassical models and offer a deeper understanding of purely speculative price runups that can be applied to FX markets. His theories, particularly the Excess Volatility Hypothesis, suggest that just like stock markets, the FX market might experience volatility that exceeds what could be justified by economic fundamentals such as interest rates, inflation rates, or balance of payments.Shiller’s integration of behavioural finance into the analysis of financial markets underscores the significant role of psychological factors in trading and investment decisions. In the FX market, this could manifest as currency values being influenced by perceptions, herd behaviour, and overreactions to news — factors that can drive the market away from fundamental values and potentially lead to speculative bubbles and abrupt corrections.
Questioning the efficient market hypothesis, Shiller proposes that markets may not always efficiently incorporate new information, a theory applicable to FX markets. Anomalies such as predictable patterns from carry trade opportunities suggest that FX markets, similar to stock markets, exhibit moments where past pricing data could help predict future movements.
Shiller advocates for a broader approach to understanding financial markets, one that includes non-economic factors such as geopolitics, market sentiment, and economic events. These factors can influence currency prices and induce large-scale speculative movements, akin to bubbles seen in other financial markets.
Shiller’s theories provide a framework for understanding the FX market that goes beyond classical economic analysis, incorporating the interplay of economic, psychological, and sociological factors. This comprehensive approach challenges the purely rational and efficient market paradigm and highlights the need for a nuanced view of FX dynamics. This broader perspective is crucial for predicting and understanding the subtleties of currency fluctuations and the often-irrational behaviour of market participants.
Enter Sornette: A Model to Predict Bubbles
When measuring bubbles, Sornette inevitably comes to mind. The researcher explores the phenomena of financial crashes and the dynamics of capital markets. He delves into the patterns and behaviours that lead to market failures, focusing on the critical concept of bubbles. Unlike traditional definitions, which rely on comparing an asset’s price with its often difficult-to-measure fundamental value, a financial bubble in this context is characterized by the detection of unsustainable movement in the asset’s price....
....MUCH MORE
Financial Crisis Observatory: Global Bubble Status Report--Oct. 1, 2014
From Didier Sornette and ETH Zurich*:And August 2014:
The Financial Crisis Observatory (FCO) is a scientific platform aimed at testing and quantifying rigorously, in a systematic way and on a large scale the hypothesis that financial markets exhibit a degree of inefficiency and a potential for predictability, especially during regimes when bubbles develop.*Swiss Federal Institute, Zürich
FCO homepage
Status report 21 page PDF
...The Honest Broker for the Week of August 16, 2014
Using valuation measures for market timing doesn't work so we're left with stuff like Zürich's Didier Sornette's thinking, links after the jump. Quick spoiler: no crash this month....
(he said with 14 days to go)
...In 2013's "UPDATED--Commodities and High Frequency Trading: Prices Being Driven By Price Moves Rather Than Fundamentals" after I called him a flake we linked to Sornette's "Quantification of the High Level of Endogeneity and of Structural Regime Shifts in Commodity Markets" (56 page PDF)
That post also linked back to:
Econophysicist Predicts Date of Chinese Stock Market Collapse--Part IIAnd FT Alphaville's wonderfully titled "Dragon-king of the outlier events".
Forecasting Financial Crashes: The Ultimate Experiment Begins
See also:
"The Illusion of the Perpetual Money Machine"
Innovation as a Social Bubble: The Example of the Human Genome Project
Via SSRN:
Power Law Scaling and "Dragon-Kings'' in Distributions of Intraday Financial Drawdown
And via Google News:
"Didier Sornette: Wir sprechen von Blasen, wenn wir ...
And more at his ETH Zürich Chair of Entrepreneurial Risks homepage