NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

On the Inception of Rational Bubbles in Stock Prices

Behzad T. Diba, Herschel I. Grossman

NBER Working Paper No. 1990 (Also Reprint No. r1082)
Issued in December 1988
NBER Program(s):   EFG   ME

This paper analyzes the theoretical possibility of rational

bubbles in stock prices in a model in which stockholders have

infinite planning horizons and in which free disposal of equity

rules out the existence of negative rational bubbles. The

analysis shows that in this framework if a positive rational

bubble exists, then it started on the first date of trading of

the stock. Thus, the existence of a rational bubble at any date

would imply that the stock has been overvalued relative to market

fundamentals since the first date of trading and that prior to

the first date of trading potential stockholders who anticipated

the initial pricing of the stock expected that the stock would be

overvalued relative to market fundamentals. The analysis also

shows that any rational bubble will eventually burst and will not

restart. Thus, even if a positive rational bubble exists,

stockholders know that after a random, but almost surely finite,

date the stock price will conform to market fundamentals forever.

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Published: Diba and Grossman, "The Theory of Rational Bubbles in Stock Prices," from Economic Journal, Vol. 98, No. 3, September 1988.

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