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Herd Behavior in Efficient Financial Markets

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  • Andreas Park
  • Hamid Sabourian

Abstract

Rational herd behavior and informationally efficient security prices have long been considered to be mutually exclusive but for exceptional cases. In this paper we describe conditions on the underlying information structure that are necessary and sufficient for informational herding. Employing a standard sequential security trading model, we argue that people may be subject to herding if and only if there is sufficient amount of noise and, loosely, their information leads them to believe that extreme outcomes are more likely than moderate ones. We then show that herding has a significant effect on prices: prices can move substantially during herding and they become more volatile than if there were no herding. Furthermore, herding can be persistent and can affect the process of learning. We also characterize conditions for contrarian behavior. Our analysis suggests that herding (and contrarian behavior) may be more pervasive than was originally thought. Hence, the paper provides a new perspective on herding in financial markets with efficient prices

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Bibliographic Info

Paper provided by University of Toronto, Department of Economics in its series Working Papers with number tecipa-249.

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Length: 44 pages
Date of creation: 03 Jul 2006
Date of revision:
Handle: RePEc:tor:tecipa:tecipa-249

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Related research

Keywords: Microstructure; Sequential Trades; Herding; Monotone Likelihood;

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References

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  1. Marco Cipriani & Antonio Guarino, 2005. "Herd Behavior in a Laboratory Financial Market," American Economic Review, American Economic Association, vol. 95(5), pages 1427-1443, December.
  2. Chari, V. V. & Kehoe, Patrick J., 2004. "Financial crises as herds: overturning the critiques," Journal of Economic Theory, Elsevier, vol. 119(1), pages 128-150, November.
  3. Marco Cipriani & Antonio Guarino, . "Herd Behavior and Contagion in Financial Markets," Working Papers 2010-01, The George Washington University, Institute for International Economic Policy.
  4. Smith, L. & Sorensen, P., 1996. "Pathological Outcomes of Observational Learning," Economics Papers 115, Economics Group, Nuffield College, University of Oxford.
  5. Roider, Andreas & Mathias Drehmann & Jorg Oechssler, 2003. "Herding and Contrarian Behavior in Financial Markets - An Internet Experiment," Royal Economic Society Annual Conference 2003 177, Royal Economic Society.
  6. Paul R. Milgrom, 1981. "Good News and Bad News: Representation Theorems and Applications," Bell Journal of Economics, The RAND Corporation, vol. 12(2), pages 380-391, Autumn.
  7. Brunnermeier, Markus K., 2001. "Asset Pricing under Asymmetric Information: Bubbles, Crashes, Technical Analysis, and Herding," OUP Catalogue, Oxford University Press, number 9780198296980, September.
  8. Lawrence R. Glosten & Paul R. Milgrom, 1983. "Bid, Ask and Transaction Prices in a Specialist Market with Heterogeneously Informed Traders," Discussion Papers 570, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
  9. Avery, Christopher & Zemsky, Peter, 1998. "Multidimensional Uncertainty and Herd Behavior in Financial Markets," American Economic Review, American Economic Association, vol. 88(4), pages 724-48, September.
  10. Banerjee, Abhijit V, 1992. "A Simple Model of Herd Behavior," The Quarterly Journal of Economics, MIT Press, vol. 107(3), pages 797-817, August.
  11. Hirshleifer, David & Teoh, Siew Hong, 2001. "Herd Behavior and Cascading in Capital Markets: A Review and Synthesis," MPRA Paper 5186, University Library of Munich, Germany.
  12. Dasgupta, Amil & Prat, Andrea, 2005. "Asset Price Dynamics When Traders Care About Reputation," CEPR Discussion Papers 5372, C.E.P.R. Discussion Papers.
  13. Sunil Sharma & Sushil Bikhchandani, 2000. "Herd Behavior in Financial Markets: A Review," IMF Working Papers 00/48, International Monetary Fund.
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Cited by:
  1. Antonio Guarino & Marco Cipriani, 2008. "Herd Behavior in Financial Markets: An Experiment with Financial Market Professionals," WEF Working Papers 0047, ESRC World Economy and Finance Research Programme, Birkbeck, University of London.
  2. Marco Cipriani & Antonio Guarino, 2008. "Herd Behavior in Financial Markets," IMF Working Papers 08/141, International Monetary Fund.

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