How to predict a stock market bubble in real time
The method departs from traditional bubble forecasting methods which involve sensitivity to model choices and require time series data of asset prices. Instead, it relies on cross-sectional option pricing data.
“It’s simple,” Dr. Kwok said. “First, get the sale prices of the stock option contracts at different strike prices. They are useful for discovering the distribution of discounted future prices of stocks. Then calculate the fundamental value of the stock as the average of the discounted future prices of the stocks. Subtract it from the observed (current) spot market prices to get bubble estimates. “
With Professor Robert Jarrow of Cornell University, he examined the daily prices of European calls and puts written on the S&P 500 Index from 1996 to 2015 and found strong evidence for the existence of bubbles. Their sizes were economically significant, accounting for over three percent of the index over the period 2006-2007, just before the onset of the 2008 global financial crisis.
“Large financial bubbles are a cause for concern because they are not sustainable and, once they burst, can lead to catastrophic loss of wealth. This is clear from the 2000 dot-com bubble and Real estate bubble of 2007“said Dr Kwok.
The method is applicable to all market indices or stocks that have options traded in liquid form. The ASX 100 index and blue-chip stocks such as those of the Big Four banks fall into this category.
A pre-print of the paper is available online and is to appear in printed form in the Journal of Applied Econometrics.