The Bubble Theory - Finance Report Paper Example

A bubble in the financial context infers to the situation where the price of an asset is much more than its fundamental value by a large margin. Prices for an asset class or financial asset are highly inflated with less precedence placed on the intrinsic value of the asset. This school of thought believes that a bubble is created by a surge in the prices of assets unwarranted by the basics of burst leading to precipitous declines prior to returning to appropriate prices (Brunnermeier, 2016). Based on this theory fathoms that huge evaluations of assets can continue for a prolonged period of time, however, they eventually burst leading to precipitous declines before getting back to the reasonable prices. The main characteristic of a bubble is the suspension of disbelief by majority of the participants during this period of bubble. During the bubble phase regular market participants as well as other models of traders are involved in speculative practice that is not supported by past valuation approaches. More often a bubble is recognized only in retrospect once the bubble has burst. An asset price bubble in most cases is always followed by a spectacular crash in the price in the amount of the securities in question. Moreover, the damage accrued as a result of a bubble burst depends on the economic sectors affected as well as whether the severity of engagement is localized or widespread. An example of a financial bubble was experienced in the United States of America. The bursting of the housing bubble in us lead to wealth destruction on worldwide basis in 2008 (Brunnermeier, 2016). This is mainly because majority of the financial institutions and banks in Europe and in the US held billions of dollars of the toxic subprime for mortgage-backed securities. The effect was huge since within the first month of 2009, the top ten largest financial institutions in the world had lost close to half of their net value. This had a negative ripple impact on other businesses making them seek financial assistance or go bankrupt.

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Market efficiency

In finance, market efficiency also commonly inferred as the efficient market hypothesis theory, is an investment theory which argues that it is not possible to beat the prevailing market since the efficiency of stock markets causes the prevailing share prices to encompass and replicate all useful information (Peirson, 2014). Based on this theory, stocks often trade at their best value on stock exchanges thus making it hard for investors to buy undervalued stocks or even sell their stocks for prices that are inflated. Therefore, it is hard outdo the overall market through market timing or expert stock selection. This leaves the only way for an investor to gain is by buying the much riskier investments.

Market Speculators

A speculator in finance refers to someone who trades commodities, derivatives, equities, bonds or currencies with a higher than the average risk in return of a higher than average profit potential. There has been an increase in the number of speculators as they take the huge risk hoping that there will be a great improvement in the prices of goods and in turn make huge gains. They are therefore complex risk-taking investors with a lot of experience in the market that they are trading in. They usually operate in shorter time frame. They must have a wider knowledge concerning the trends that have been taking place in the market. A perfect example to explain a speculator is an investor that is predicting that an organization that is experiencing or has been experiencing difficulties like bankruptcy or highly negative press event will have a quick recovery from the situation. An investor putting his funds in such company is a speculator as he only hopes on the positive future outcomes. There are principles that guide the speculator before they engage in their trading. Being that speculative activities are always associated with a higher risk because of the market indicators that do not show the possibility of asset appreciation, the speculators must know the trends in that industry before investing. This makes them purchase futures over the traditional stocks.

Inside Trading

Inside trading refers to the buying or selling of security by an individual that has access to the material nonpublic information concerning the security. This practice is however considered illegal when the information regarding the product is still nonpublic. It should also be noted that having special knowledge is unfair to other investors that cannot access the information. Therefore, legal inside trading takes place directors of the organization sell or purchase the shares though they must disclose their transactions legally (Arruda, et al. 2016). There are rules from the Securities and Exchange Commission that protects investments from the aftermath of inside training. In the recent past, a large percentage of people who have been conducting inside trading have been doing it negatively. Legal inside training normally takes place on a weekly basis in the stock market. To ensure that this protected, the SEC ensures that the transactions are electronically submitted in the correct time. They must also be disclosed on the website of the organization that is trading. It is, therefore, advisable to all the parties that are conducting the inside trading to look into the terms and conditions of the inside trading to avoid engaging in illegal inside trading.

References

Arruda, M. P., Lipka, A. E., Brown, P. J., Krill, A. M., Thurber, C., Brown-Guedira, G., ... & Kolb, F. L. (2016). Comparing genomic selection and marker-assisted selection for Fusarium head blight resistance in wheat (Triticum aestivum. Molecular Breeding, 36(7), 1-11.

Brunnermeier, M. K. (2016). Bubbles. In Banking Crises (pp. 28-36). Palgrave Macmillan UK.

Peirson, G., Brown, R., Easton, S., & Howard, P. (2014). Business finance. McGraw-Hill Education Australia.