The Theory of Rational Bubbles in Stock Prices

Behzad Diba and Herschel Grossman

Economic Journal, 1988, vol. 98, issue 392, 746-54

Abstract: Free disposal of equity, which directly rules out the existence of negative rational bubbles in stock pric es, also imposes theoretical restrictions on the possible existence o f positive rational bubbles. The analysis in this paper shows that a positive rational bubble can start only on the first date of trading of a stock. Thus, the existence of a rational bubble at any date woul d imply that the stock has been overvalued relative to market fundame ntals since the first date of trading, and that prior to the first da te of trading the issuer of the stock and potential stockholders who anticipated the initial pricing of the stock expected that the stock would be overvalued. Copyright 1988 by Royal Economic Society.

Date: 1988
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