Statistical modelling of financial crashes: Rapid growth, illusion of certainty and contagion

Abstract

We develop a rational expectations model of financial bubbles and study ways in which a generic risk-return interplay is incorporated into prices. We retain the interpretation of the leading Johansen-Ledoit-Sornette model, namely, that the price must rise prior to a crash in order to compensate a representative investor for the level of risk. This is accompanied, in our stochastic model, by an illusion of certainty as described by a decreasing volatility function. The basic model is then extended to incorporate multivariate bubbles and contagion, non-Gaussian models and models based on stochastic volatility. Only in a stochastic volatility model where the mean of the log-returns is fixed does volatility increase prior to a crash.financial crashes; super-exponential growth; illusion of certainty; contagion