Asset bubbles in underdeveloped financial markets with influential DC pension funds: evidence from the Croatian financial market

In the mid-1990s, the World Bank promoted a major reform of the pension systems in developing and transition economies; namely, the introduction of mandatory defined contribution pension schemes. Yet this was not accompanied by thorough analysis of the potentially speculative valuation side effects of influential institutional investors being introduced into underdeveloped financial markets. In this Dissertation we developed a theoretical Overlapping Generations Model (OLG) with rational asset bubbles and influential institutional Defined Contribution (DC) pension funds. We report empirical evidence, based on data from the Croatian financial market, which confirms predictions of our theoretical model: namely, that when the financial market becomes dynamically inefficient, introduction of influential DC pension funds significantly increases the incidence and the intensity of the bubbly asset episodes. The empirical evidence also confirms that the shock of return to dynamic efficiency on the financial market, caused by the Global Financial Crisis, resulted in a sudden and swift collapse of the bubbly Croatian equity market. We begin the Dissertation with a retrospect of the Efficient Market Hypothesis and the empirical evidence on asset price misevaluation episodes. The Efficient Market Hypothesis was contested with respect to its “joint hypothesis problem” contained in the distinction between the information efficiency of financial markets and the efficiency of financial market asset valuation. Major empirical evidence questioning asset valuation efficiency led to the development of four major theories of asset bubbles, which we treat in detail. We focus on the Rational Asset Bubbles theory as the most compelling and we use it in our own theoretical modelling. Building on a model developed by Jean Tirole (1985), we develop an original OLG Rational Asset Bubbles model with mandatory DC Pension funds as influential institutional investors. We inspect the dynamics of the modelled financial market using Phase Diagrams to derive the hypothesis that the introduction of a mandatory DC pension fund in a dynamically inefficient financial market leads to a higher state of the rational asset bubble. We also hypothesise that a sudden change in the dynamic efficiency of the financial market could lead to a swift crash of the rational asset bubble in such a market environment.