CCGL9030

Bubbles and Crashes Paper 1 by Wu Kunhuan

Format: Open Book Time: 3 hours Full mark: 100

This is an open-book examination. Candidates may bring to their examination any

printed/written materials.

Name: _____________________________ UID: __________________ Date: __________________

Part A (20 marks)

This part contains some multiple-choice questions. For each question, select the best option(s) among all the
options given. 2 marks will be awarded if you selected all the options correctly, and 1 mark for partially
selected options. No mark will be given if no option is selected or the wrong options are chosen.

Part B (60 marks)

This part contains short-answer questions. Please answer as detailed as possible.

Part C (20 marks)

This part contains problem-solving questions. Please answer as detail as possible.

Part Question Max Your Mark

Part A Q1~5 20

Q1 30

Part B Q2 15

Q3 15

Part C Q1 20

100
 Part A (20 marks)

The above diagram shows the trend of the Hong Kong Housing Price Index from 1992 to 2022.
Answer Question 1~2.

1. In the diagram above, (roughly) when do(does) bubbles appear?

a. 1995-1997
b. 1997-1998
c. 2003-2015
d. 2018-2022
e. None of the above

2. What was(were) some factors in history that contributed to the above bubble(s) in
the Hong Kong housing market?
a. Estimation of increasing estate price after the handover of sovereignty.
b. A significant decrease in affordable private housing options in Hong Kong.
c. Increased anti-speculative measures implemented by the Hong Kong government.
d. Asia's Financial Crisis and followed-up recession reduced investment costs for locals.
Effective investment strategies provide a structured approach to decision-making, ensuring
informed choices and long-term success, which are crucial for maximizing returns, managing
risks, and achieving financial goals. Warren Edward Buffett is one of the best-known investors
in the world as a result of his immense investment success. He also gives good explanations
of how bubbles are formed. Answer Question 3~7.

3. Which of the following pictures is Warren Buffett?

a. Choice b. Choice

c. Warren Buffett d. Choice

4. Which of the following famous investment quote(s) come(s) from Warren Buffett?
a. Just hold the goddamn stock.
b. Compound interest is the eighth wonder of the world.
c. Investing should be more like watching paint dry or watching grass grow.
d. The most important quality for an investor is temperament and not intellect.
e. The stock market is like the weather, in that if you do not like the current conditions, all
you have to do is wait.
f. I will tell you how to become rich. Close the doors. Be fearful when others are greedy.
Be greedy when others are fearful.
In 2011, the European sovereign debt crisis and the risk of U.S. debt default were basically
beyond the company's control, and Bank of America's stock price fell sharply. Warren Buffett
struck one of the most lucrative deals of his career by injecting $5 billion into Bank of America.

5. Which crisis did Warren Buffett's move save Bank of America from?
a. Liquidity crisis
b. Debt-ceiling crisis
c. Excessive leverage crisis
d. Subprime mortgage crisis

The 2018 cryptocurrency crash was the sell-off of most cryptocurrencies starting in January
2018. After an unprecedented boom in 2017, the price of Bitcoin fell by about 65% in a month
in 2018. Warren Buffett has expressed scepticism about Bitcoin, considering it a “delusion,”
while recognizing the importance of blockchain technology. In addition, they do not generate
cash flow or continuous profits, which is an unsustainable investment and a bubble.

On the other hand, some have argued that the "correct investment" we learned in the past as
Warren Buffet did is no longer applicable to the next era.

6. Which of the following statements is(are) appropriate regarding the context?

a. Technological progress has promoted the rapid transformation of products, which in
turn accelerates changes in people’s preferences.
b. Modern people pay more focus to instant opportunities like Bitcoin and AI as they
become more and more time-sensitive and cannot be missed.
c. The traditional Buffett's investment style is the "value investment", which pays more
attention to a company's fundamentals such as cash flow and profitability.
d. Buffett's "Fear is contagious" warning on the banking crisis can be adapted to the
Bitcoin bubble as it shows people's overlook of behaviour interactions.
7. According to Warren Buffett's experience, the cryptocurrency crash, and what you
have learned from the lecture, what are the conditions for bubbles to happen?
a. Bubble can exist when there is no uncertainty on goods' price.
b. People tend to lack awareness when the bubble continues to grow.
c. Government policies like financial liberalisation contribute to bubble formation.
d. Bubble formations in asset prices can be totally attributed to agents misbehaving.

8. What are some of the major consequences of financial bubbles?

a. Leveraged buyers' defaults
b. Banks' liquidity crunches
c. Exchange rate crisis
d. Persistent recession

9. Which of the following correctly describe(s) the nature of risky debts?

a. Banks can require investors to provide investment decisions that the debt is involved
before providing risky debt.
b. Banks can preserve the interests of creditors and get the debt back by denying a borrower's
files for bankruptcy if the borrower shifts the risk.
c. Banks can adjust the borrowing costs (e.g., change the interest rates) to change the
risk level of the lenders' side and prevent possible credit risks.
d. Banks can make use of measures of borrowing costs such as yield spreads to estimate
the credit risk levels of participants before deciding whether to offer risky debts.

10. Irrational bubbles involve unrealistic expectations about an asset’s prospects, but
rational bubbles mean agents expect a price increase of at least r%, otherwise the agents
will not carry them. Among the following bubbles, which possibly had rational ones?
a. Tulipmania Bubble
b. South Sea Bubble
c. Dotcom Bubble
d. None of the above
 Part B (60 marks)

1. (30 marks) Glossary. Fill in the terminology in the space according to the description,
and answer the followed-up question briefly:

(a) _ Bankrupt _ is the state that is unable to pay what you owe by a court of law
given that you have control of your financial matters. In other words, the person is
declared in law as unable to pay their debts. What are some things that you cannot do
after being declared to have this state in Hong Kong?

1. Act as a company director and may not be able to practise in certain

professions such as a lawyer, estate agent, insurance agent, etc.
2. Cannot purchase luxuries such as buying cars or travelling overseas
unless they have reasonable grounds to do so

(b) _ Non-pecuniary Costs _ are costs that cannot be easily measured in monetary
terms. What are some examples of this kind of cost in an investment?

1. Emotional costs: Investing can be a stressful activity, individuals

may experience emotional costs such as anxiety and fear.
2. Time and effort: Investment decisions often require extensive
research, analysis, and monitoring.
3. Poor investment decisions can negatively impact an individual's
reputation within the investment community.
4. Regulatory compliance costs: Compliance with various regulations,
reporting requirements, and legal obligations in the industry.

(c) _ Portfolios _ are collections of investments and holdings like stocks, bonds,
commodities, crypto, cash, and cash equivalents in finance. What is the generally
accepted principle used when investors design them?

When designing portfolios, investors typically follow the principle of

diversification. Diversification is the practice of spreading investments
across different asset classes, sectors, regions, or types to reduce the
overall risk by avoiding overexposure to any single investment.
 (d) _ Consumer goods _ are any tangible commodity produced and subsequently
purchased to satisfy buyer's demands. What are some categories of them?

1. Fast-moving consumer goods (FMCG): Everyday items that are

typically consumed or replaced frequently, such as food and beverages,
toiletries, cleaning products, and personal care items.
2. Durables: Consumer goods that have a longer lifespan and are
intended to be used over an extended period, including appliances,
electronics, furniture, automobiles, etc.
3. Entertainment and leisure products: Books, movies, video games,
sporting goods, musical instruments, and recreational equipment.

(e) _ House Price Index (HPI) _ measures the price changes of residential housing
as a percentage from some specific start date. In the following diagram (source:
https://news.yahoo.com/private-public-housing-performed-better-140801749.html),
which year is the price level based? Why is that year often used as the benchmark?

The House Price Index (HPI) is typically measured against 1999 as the
base year above, as both PPI and HDB are 100. 1999 was chosen as a
benchmark because it is a reasonable year where there were no major
events like wars or financial crises that could skew the data.
 (f) _ Leases _ are contractual arrangements calling for the user to pay the owner for
the use of an asset. Give some examples of the assets that can be mentioned in the
above arrangements. What are the relationships between the user & the owner and the
corresponding asset under the agreement?

Examples of assets that can be mentioned in lease agreements include

real estate, vehicles, equipment, land, intellectual property, etc.
Under the lease agreement, the lessee (user) has the right to possess
and use the asset for the agreed-upon duration. The lessee pays
periodic rental payments to the lessor (owner) in return for the use of
the asset. The lessor retains ownership of the asset throughout the
lease term and may impose certain conditions or restrictions on its use.

(g) _ Tulip Mania/Tulip Bubble _ was a period during the Dutch Golden Age when
contract prices for recently introduced fashionable bulbs reached extraordinarily high
levels. State the accurate year that the above bubble burst. What type of bubble it was?
What is this word used to describe today?

The accurate year when this bubble burst is 1637. It was a speculative
bubble/asset bubble in the Netherlands, specifically in the trade of
tulip bulbs. The term is now often used metaphorically to refer to any
large economic bubble when asset prices deviate from intrinsic values.

(h) _ Options/Option Contracts _ are promises to keep an offer open for another
party to accept, but not the obligation to buy or sell some underlying security at a pre-
specified price within a period. What is the terminology for the corresponding price?
For the two categories of the promises, what does the above price represent?

The terminology for the corresponding price is the "strike price" or

"exercise price." It represents differently under two categories:

Call Options: It represents the price at which the holder can purchase
the underlying security if they choose to exercise the option.
Put Options: It represents the price at which the holder can sell the
underlying security if they choose to exercise the option.
 (i) _ Too Big To Fail (TBTF) _ is a theory that asserts that certain corporations',
particularly financial institutions' failure would be disastrous to the greater economic
system. Analyze the major cause of Lehman Brothers' failure in 2008.

1. Subprime Mortgage Exposure: Lehman Brothers had significant

exposure to subprime mortgages. The subprime mortgage crisis
resulted in great losses due to the declining value of these assets.
2. Lack of Sufficient Liquidity: Lehman Brothers did not have enough
available cash to meet obligations due to their heavy reliance on short-
term funding and a loss of confidence from creditors and investors.

(j) _ Liquidation Value _ is the likely asset value that will be received by the holder
when it is sold in insufficient time, typically under a rapid sale. Give at least two
circumstances in which the value is used to calculate the total value of assets.

1. Bankruptcy proceedings: When a company goes bankrupt, its assets

may need to be rapidly sold off to repay debts. Liquidation value would
be used to estimate how much the fire sale of assets could raise to
satisfy creditors' claims.

2. Margin calls: If an investor has borrowed money (using leverage) to

purchase securities, and the value of those securities drops below a
minimum level, the broker may issue a margin call requiring the
investor to deposit more money. Liquidation value would be used in
determining if the securities have sufficient value to cover the
outstanding loan if sold rapidly.
2. (15 marks) Bubbles occur with market economy changes and government management
and reflect the financial status of a society. Answer the following questions.

(a) (8 marks) Give your understanding of each of the following claims. You may
support (defend) or oppose (attack) them given your perspective is clear.

(1) When there is a bubble, it will burst.

This claim is generally true. Bubbles typically occur when the prices of
assets, such as stocks, real estate, or cryptocurrencies, become detached
from their underlying fundamental value and rise to unsustainable
levels. Eventually, market forces or a change in investor sentiment will
result in a correction, leading to a significant decline in prices. This
correction is often referred to as a "bursting" of the bubble.

Supporting Perspective: A bubble is characterized by excessive

speculation and investor optimism, leading to inflated asset prices.
However, this optimism is not sustainable in the long term, as it is not
supported by fundamental factors such as earnings, valuations, or
economic conditions. Eventually, market forces will prevail, causing
the bubble to burst and prices to decline. This can result in financial
losses for investors who bought into the bubble at inflated prices.

Opposing Perspective: In some cases, asset price bubbles may

experience a gradual correction without a sudden burst. Government
intervention or market manipulation can sometimes delay or mitigate
the bursting of a bubble. Therefore, while bubbles generally tend to
burst, the timing and severity of the burst can vary.
 (2) Bubbles will always come back in a financial market.

This claim is not universally true. While financial markets have

experienced recurring bubbles throughout history, it is not guaranteed
that bubbles will always resurface.

Supporting Perspective: Bubbles can result from various factors,

including excessive leverage or market inefficiencies. As long as they
persist, the potential for future bubbles remains. Additionally, human
psychology and herd behaviour can contribute to new bubbles over
time. Therefore, bubbles can reemerge in financial markets.

Opposing Perspective: The claim that bubbles will always come back
overlooks the lessons learned from past market bubbles and the efforts
made to prevent their recurrence. Regulatory measures, improved risk
management practices, and increased market transparency can help
mitigate the formation and impact of bubbles.

(b) (2 marks) There are different businesses on the market, which can be divided into
whether they are profitable and whether they are beneficial to society. In each case, will
government involvement in regulation be required? Fill in Yes or No.

Profitable Non-Profitable

Beneficial to Society No Yes

Non-beneficial to Society Yes No

 (c) (5 marks) Uncertainty about payoffs in a real or financial sector can lead to
bubbles in an intermediated financial system due to risk shifting and asset substitution
behaviours. Explain why this is the case.

Institutions, such as banks, act as intermediaries by accepting deposits

from savers and providing loans and other financial services to
borrowers. In an intermediated financial system, financial institutions
play a crucial role in channelling funds from savers to borrowers.

When there is uncertainty about payoffs in the real or financial sector,

it creates a situation where the expected returns on investments
become uncertain. Financial institutions may seek higher returns by
taking on riskier investments or allocating funds to sectors or assets
with higher potential payoffs but also higher inherent risks.

The above behaviour in financial institutions can be driven by the

expectation of higher returns or the desire to meet KPIs. In the end, it
can drive up the prices of those risky assets in an unsustainable way.

As the bubble grows, market participants may believe that the prices
will rise indefinitely. However, when the uncertainty about payoffs
eventually becomes clear or market conditions change, the bubble
bursts, resulting in a sharp decline in asset prices.
2. (15 marks) Futures and Options are contracts between two parties (say party A and
party B) to do a transaction in the future with the contract terms fixed today. Consider
the scenario where Peter enters into a contract with Mary to buy ① a certain number of
shares of HSBC at the end of 6 months for HK$60 per share, and ② 6-month term
deposit in the HSBC bank where the unit is HK$100.

(a) (6 marks) Model the investment as a future contract without options. In your
model, consider uncertainty, non-pecuniary convex cost, portfolio combinations,
purchase units, etc. Based on the values, calculate the payoff of Peter (investor).
Summarize by providing an approach to fixing the investment decision of Peter.

Investment ①: Peter agrees to buy <x> shares of HSBC from Mary

in 6 months. The price is fixed at HK$60 per share as agreed in the
contract today. Mary agrees to sell x shares to Peter at that price.

Investment ②: Peter deposits HK$100 * <y> in the HSBC term

deposit (where <y> is the number of deposit units). The interest rate on
the 6-month deposit is <r>%.
The portfolio is made up of the Investments ① (risky) and ② (safe).
In practice, if Mary’s total capital is fixed to <z>, and the portfolio
ratio of ① is <p>, then <x> = <z><p>, and <y> = <z>(1 - <p>).

Non-pecuniary convex cost: Peter incurs anxiety from the uncertainty

of the future HSBC stock price. Diversifying into the deposit by
reducing <p> helps reduce this non-pecuniary convex cost. A common
option is to use 0.05<p>^2 to denote the non-pecuniary cost.

Payoffs: Denote <price> to the HSBC share price after 6 months.

Peter's payoff = <x>*(<price> - 60) + <y>*100<r> - 0.05<p>^2
= <z><p>(<price> - 60) + 100<z>(1 - <p>)<r> - 0.05<p>^2

To find the optimal investment decision, an approach is to calculate

the expectation of <price>, take the derivative of the above payoff
concerning <p> and set it equal to 0. This gives us
<p> = min(1, max(0, <z>(E(<price>) - 60)/0.1)). It should be noted
that in reality, it is difficult to estimate E(<price>), and Peter's
behaviour in buying the risky asset ① is not necessarily rational.
 (b) (4 marks) Suppose Peter and Mary formulate future contracts with options. Both
parties will take actions that maximise their returns. Consider the investment ① only.
Complete the form for different circumstances of HSBC share prices after 6 months for
each share involved in the contract.

6-mo Price 6-mo Future Contract (Call) 6-mo Future Contract (Put)
of HSBC Peter Mary Peter Mary
$50 $0 (do not exercise) $0 $50 - $60 = -$10 $10 (exercise)

$60 $0 (do not exercise) $0 $0 $0 (do not exercise)

$70 $10 (exercise) $60 - $70 = -$10 $0 $0 (do not exercise)

(c) (2 marks) To see the bubble, we need to compare the equilibrium price of the risky
asset <price> with the fundamental value <price*>. Suggest a definition of it that helps
the investors to find the fundamental value and the bubble.

The fundamental value (<price*>) is defined as the expected present

value of the risky asset's future cash flows that an investor would be
willing to pay in the absence of risk shifting. In other words, the
investor must retain and cannot shift/hedge the risk through other
means like purchasing insurance or selling the risk to a bank. In this
context, the bubble can be defined as <price> - <price*>.

(d) (3 marks) In the above example, based on the definition you proposed, analyze
and indicate which variables can be used to calculate <price*>.

1. Expected future cash flows (dividends, profits, etc) from holding the
risky asset. This captures the underlying earnings generation ability.
2. Discount rate - this should reflect the risks and required return for
holding the asset. A lower discount rate would yield a higher <price*>.
3. The portfolio preference of the investors in general. A shift in the
portfolio ratio will affect the feasible pricing of risky assets.
 Part C (20 marks)

1. Read the required paper The Credit Crisis of 2008: An Overview by HBS. Answer the
following questions.

(a) (4 marks) Systematically summarise the origins of the 2008 credit crisis according
to HBS's introduction. Interpret the interactions between governments, GSEs, rating
agencies, markets and other factors.

1. Housing Bubble and Subprime Lending

The crisis originated from the housing market, where a housing bubble
formed due to excessive speculation and inflated prices. Subprime
lending played a significant role, as lenders offered mortgages with low
creditworthiness, often with adjustable interest rates.

2. Bank Securitization and Rating Agencies' risk ignorance

Investment banks created mortgage-backed securities (MBSs) by
packaging these mortgages and selling them to investors. Rating
agencies assessed the risk of these securities, often assigning them high
ratings despite underlying risks.

3. Government-Sponsored Enterprises (GSEs)

Entities like Fannie Mae and Freddie Mac played a crucial role in the
mortgage market by purchasing and guaranteeing MBSs. Their implicit
government backing led investors to believe these securities were safe.

4. Lack of Transparency and Risk Management

There was a lack of transparency regarding the true value and risk
associated with MBSs and related financial instruments. Financial
institutions relied heavily on complex models to measure risk, which
proved to be inaccurate during the crisis.
 (b) (4 marks) In the "The Rise of Subprime" section, point out at least 4 signs that
bubbles grow. If necessary, point out connections between these signs.

1. Financial Innovation and Increased Liquidity

Fast financial innovation and mortgage-backed investments led to
increased real estate liquidity, driven by historically low-interest rates.

2. Easing of Lending Requirements

Legal and congressional pressure on banks to ease lending
requirements for low-income buyers resulted in a proliferation of
subprime lending to borrowers with questionable creditworthiness.

3. Aggressive Marketing and Questionable Lending Practices

Lenders aggressively marketed to potential homebuyers, offering loans
with higher interest rates, flexible terms, and minimal documentation,
contributing to the expansion of subprime lending.

4. Perception of Ever-Increasing House Prices

The belief in continuously rising house prices created a perception that
real estate investments were safe and profitable, leading buyers to take
on more debt with the assumption that they could easily refinance.
 (c) (4 marks) Describe in detail the process of the 2008 Credit Crisis bubble burst.
Elaborate precisely and concisely on the impact of the Credit Crisis on the government,
the credit market, companies (including banks) and taxpayers (the general public).

1. Government
The crisis led to significant interventions by the government, including
the bailout of financial institutions, implementation of stimulus
packages, and regulatory reforms to stabilize the financial system.

2. Credit Market
The credit market froze as banks became reluctant to lend due to high
levels of uncertainty and risk. This made businesses and consumers
obtain credit for investment and consumption.

3. Companies (including banks)

Many financial institutions faced severe losses and some even faced
bankruptcy, which exposed weaknesses in risk management practices,
leading to low public banking sector confidence.

4. Taxpayers (the general public)

The government's interventions and bailouts required taxpayer funds,
and the overall economic downturn resulted in job losses, decreased
home values, and reduced personal wealth.

In conclusion, the Crisis had a systemic impact, leading to a severe

recession, high unemployment rates, and a decline in economic growth.
 (d) (4 marks) What measures has the US government taken to mitigate this credit
risk? Why couldn't they immediately re-stimulate the credit market?

Several measures to mitigate the credit risk included:

1. Bailouts and Recapitalization

Financial assistance to troubled institutions such as Bear Stearns and
AIG to prevent their collapse and stabilize the financial system.

2. Stimulus Measures
The government provided stimulus funds on “shovel-ready” projects to
try to jump-start the real economy and save industries e.g. automobiles.

3. Regulatory Reforms
New regulations were introduced to enhance oversight and financial
risk management, including the “stress tests” to determine if banks had
enough capital to face downturns.

The immediate re-stimulation of the credit market after the 2008 credit
crisis faced challenges from the public side. Loss of confidence, risk
aversion, tightened lending standards, regulatory reforms, and
economic uncertainty hindered the restoration of credit activities.

In addition, it takes time for public confidence and trust in the

financial system, along with addressing stricter regulations and
economic uncertainties, which were crucial for overcoming these
challenges and gradually revitalizing the credit market.
 (e) (4 marks) What do you think the U.S. government can do to avoid similar risks
from happening, and why? Analyze based on the facts mentioned in the paper.

The US government can consider the following measures:

1. Strengthening Regulatory Oversight

Enhance financial regulations and oversight for transparency, risk
management, and accountability. Regular assessments of financial
institutions' risk exposure to identify potential vulnerabilities.

2. Promoting Responsible Lending Practices

Encourage responsible lending standards and discourage the issuance
of risky mortgage products. Stricter regulations can be implemented to
ensure borrowers repay loans and prevent unsustainable debt.

3. Improving Risk Assessment and Rating Agency Practices

Enhance risk assessment models and ensure rating agencies provide
accurate and independent evaluations of financial instruments.

4. Building Robust Crisis Management Frameworks

Develop comprehensive crisis management frameworks that enable
swift and effective responses in times of financial distress.

5. International Cooperation and Coordination

Foster international cooperation and coordination to address global
financial risks. Establish consistent regulatory standards, enhance
information sharing and prevent regulatory arbitrage.

- END OF THE PAPER -