Herd Behavior in Efficient Financial Markets

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Herd Behavior in Efficient Financial Markets

Author Info

Andreas Park
Hamid Sabourian

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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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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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Find related papers by JEL classification:
C70 - Mathematical and Quantitative Methods - - Game Theory and Bargaining Theory - - - General
D80 - Microeconomics - - Information, Knowledge, and Uncertainty - - - General
D83 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Search, Learning, and Information
D84 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Expectations; Speculations
G12 - Financial Economics - - General Financial Markets - - - Asset Pricing
G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies

This paper has been announced in the following NEP Reports:

NEP-ALL-2006-08-19 (All new papers)
NEP-FIN-2006-08-19 (Finance)
NEP-FMK-2006-08-19 (Financial Markets)
NEP-MST-2006-08-19 (Market Microstructure)

References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:

Banerjee, Abhijit V, 1992. "A Simple Model of Herd Behavior," The Quarterly Journal of Economics, MIT Press, vol. 107(3), pages 797-817, August. [Downloadable!] (restricted)
repec:bep:thecon:v:8:y:2008:i:1:p:1390-1390 is not listed on IDEAS
V. V. Chari & Patrick J. Kehoe, 2003. "Financial Crises as Herds: Overturning the Critiques," NBER Working Papers 9658, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
Other versions:
- V. V. Chari & Patrick J. Kehoe, 2003. "Financial crises as herds: overturning the critiques," Staff Report 316, Federal Reserve Bank of Minneapolis. [Downloadable!]
- 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. [Downloadable!] (restricted)
Sunil Sharma & Sushil Bikhchandani, 2000. "herd Behavior in Financial Markets - A Review," IMF Working Papers 00/48, International Monetary Fund.
Lones Smith & Peter Sorensen, 2000. "Pathological Outcomes of Observational Learning," Econometrica, Econometric Society, vol. 68(2), pages 371-398, March.
Other versions:
- Smith, L. & Sorensen, P., 1996. "Pathological Outcomes of Observational Learning," Working papers 96-19, Massachusetts Institute of Technology (MIT), Department of Economics.
- Smith, L. & Sorensen, P., 1996. "Pathological Outcomes of Observational Learning," Economics Papers 115, Economics Group, Nuffield College, University of Oxford.
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. [Downloadable!]
Other versions:
- David Hirshleifer & Siew Hong Teoh, 2003. "Herd Behaviour and Cascading in Capital Markets: a Review and Synthesis," European Financial Management, Blackwell Publishing Ltd, vol. 9(1), pages 25-66. [Downloadable!] (restricted)
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. [Downloadable!] (restricted)
Other versions:
- Paul R. Milgrom, 1979. "Good Nevs and Bad News: Representation Theorems and Applications," Discussion Papers 407R, Northwestern University, Center for Mathematical Studies in Economics and Management Science. [Downloadable!]
Dasgupta, Amil & Prat, Andrea, 2005. "Asset Price Dynamics When Traders Care About Reputation," CEPR Discussion Papers 5372, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
Mathias Drehmann & Jorg Oechssler & Andreas Roider, 2005. "Herding and Contrarian Behavior in Financial Markets: An Internet Experiment," American Economic Review, American Economic Association, vol. 95(5), pages 1403-1426, December. [Downloadable!]
Other versions:
- Mathias Drehmann & Joerg Oechssler & Andreas Roider, 2003. "Herding and Contrarian Behavior in Financial Markets: An Internet Experiment," University of California at Santa Barbara, Economics Working Paper Series 18-03, Department of Economics, UC Santa Barbara. [Downloadable!]
- Mathias Drehmann & Joerg Oechssler & Andreas Roider, 2002. "Herding and Contrarian Behavior in Financial Markets - An Internet Experiment," Finance 0210005, EconWPA. [Downloadable!]
- Mathias Drehmann & Jörg Oechssler & Andreas Roider, 2004. "Herding and Contrarian Behavior in Financial Markets - An Internet Experiment," Discussion Papers 7, SFB/TR 15 Governance and the Efficiency of Economic Systems, Free University of Berlin, Humboldt University of Berlin, University of Bonn, University of Mannheim, University of Munich. [Downloadable!]
- Mathias Drehmann & Joerg Oechssler & Andreas Roider, 2002. "Herding and Contrarian Behavior in Financial Markets - An Internet Experiment," Experimental 0210001, EconWPA. [Downloadable!]
- 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. [Downloadable!]
- Mathias Drehmann & Jörg Oechssler & Andreas Roider, 2002. "Herding and Contrarian Behavior in Financial Markets - An Internet Experiment," Bonn Econ Discussion Papers bgse25_2002, University of Bonn, Germany, revised Apr 2003. [Downloadable!]
- Mathias Drehmann & Jörg Oechssler, 2004. "Herding and Contrarian Behavior in Financial Markets - An Internet Experiment," Econometric Society 2004 North American Winter Meetings 55, Econometric Society. [Downloadable!]

Full references

Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

Antonio Guarino & Marco Cipriani, 2008. "Herd Behavior in Financial Markets: An Experiment with Financial Market Professionals," IMF Working Papers 08/141, International Monetary Fund. [Downloadable!]
Other versions:
- 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. [Downloadable!]
- Marco Cipriani & Antonio Guarino, 2009. "Herd Behavior in Financial Markets: An Experiment with Financial Market Professionals," Journal of the European Economic Association, MIT Press, vol. 7(1), pages 206-233, 03. [Downloadable!] (restricted)

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