Working Papers

What is the relative importance of different bubble mechanisms over the life cycle of a bubble? Using account-level data covering 18 million retail accounts and all institutions at a major stock exchange and a demand system adapted to the Chinese market, we find that the 2015 stock market bubble begins with changes in stock characteristics. Both decomposition and counterfactual analyses show that retail trading —through new investor participation and leveraged trading —plays an important role during the bubble boom-bust. Our results accord with the classic narrative of Kindleberger (1978) and offer insights into other bubble episodes.

Building on the recently developed demand system asset pricing theory, we offer a novel explanation for liquidity risk from the perspective of investor demand. Using demand elasticity as a proxy of investor demand, we theoretically establish a negative relationship between demand elasticity and liquidity risk, which is subsequently supported by empirical evidence. Our findings show that liquidity risk, measured by the bid-ask spread or Amihud illiquidity, decreases monotonically as demand elasticity increases, and this relationship remains robust to various controls. Furthermore, we demonstrate that demand elasticity, as a key driver of liquidity risk, exhibits robust predictive power for stock returns, compared to traditional liquidity risk measures.