Asset Price Bubbles

Abstract

This article reviews the theoretical literature on asset price bubbles, with an emphasis on the martingale theory of bubbles. The key questions studied are as follows: First, under what conditions can asset price bubbles exist in an economy? Second, if bubbles exist, what are the implications for the pricing of derivatives on the bubble-laden asset? Third, if bubbles can exist, how can they be empirically determined? Answers are provided for three frictionless and competitive economies with increasingly restrictive structures. The least restrictive economy just assumes no arbitrage. The next satisfies no arbitrage and no dominance. The third assumes the existence of an equilibrium.