Liquidity induced asset bubbles via flows of ELMMs

Abstract

We consider a constructive model for asset price bubbles, where the market price $W$ is endogenously determined by the trading activity on the market and the fundamental price $W^F$ is exogenously given, as in the work of Jarrow, Protter and Roch (2012). To justify $W^F$ from a fundamental point of view, we embed this constructive approach in the martingale theory of bubbles, see Jarrow, Protter and Shimbo (2010) and Biagini, Föllmer and Nedelcu (2014), by showing the existence of a flow of equivalent martingale measures for $W$, under which $W^F$ equals the expectation of the discounted future cash flow. As an application, we study bubble formation and evolution in a financial network.

33 pages