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Transaction costs and informational cascades in financial markets: Theory and experimental evidence

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  • Cipriani, Marco
  • Guarino, Antonio

Abstract

We study the effect of transaction costs (e.g., a trading fee or a transaction tax, like the Tobin tax)on the aggregation of private information in financial markets. We analyze a financial market à la Glosten and Milgrom, in which informed and uninformed traders trade in sequence with a market maker. Traders have to pay a cost in order to trade. We show that, eventually, all informed traders decide not to trade, independently of their private information, i.e., an informational cascade occurs. We replicated our financial market in the laboratory. We found that, in the experiment, informational cascades occur when the theory suggests they should. Nevertheless, the ability of the price to aggregate private information is not significantly affected. JEL Classification: C92, D8, G14

Suggested Citation

  • Cipriani, Marco & Guarino, Antonio, 2007. "Transaction costs and informational cascades in financial markets: Theory and experimental evidence," Working Paper Series 736, European Central Bank.
    • Handle: RePEc:ecb:ecbwps:2007736
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    References listed on IDEAS

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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. Glosten, Lawrence R. & Milgrom, Paul R., 1985. "Bid, ask and transaction prices in a specialist market with heterogeneously informed traders," Journal of Financial Economics, Elsevier, vol. 14(1), pages 71-100, March.
    3. Ian Domowitz & Jack Glen & Ananth Madhavan, 2001. "Liquidity, Volatility and Equity Trading Costs Across Countries and Over Time," International Finance, Wiley Blackwell, vol. 4(2), pages 221-255.
    4. Chamley,Christophe P., 2004. "Rational Herds," Cambridge Books, Cambridge University Press, number 9780521530927.
    5. Gale, Douglas, 1996. "What have we learned from social learning?," European Economic Review, Elsevier, vol. 40(3-5), pages 617-628, April.
    6. Chamley,Christophe P., 2004. "Rational Herds," Cambridge Books, Cambridge University Press, number 9780521824019.
    7. David Hirshleifer & Siew Hong Teoh, 2003. "Herd Behaviour and Cascading in Capital Markets: a Review and Synthesis," European Financial Management, European Financial Management Association, vol. 9(1), pages 25-66, March.
    8. Mr. Karl F Habermeier & Mr. Andrei A Kirilenko, 2001. "Securities Transaction Taxes and Financial Markets," IMF Working Papers 2001/051, International Monetary Fund.
    9. Avery, Christopher & Zemsky, Peter, 1998. "Multidimensional Uncertainty and Herd Behavior in Financial Markets," American Economic Review, American Economic Association, vol. 88(4), pages 724-748, September.
    10. Domowitz, Ian & Glen, Jack & Madhavan, Ananth, 2001. "Liquidity, Volatility and Equity Trading Costs across Countries and over Time," International Finance, Wiley Blackwell, vol. 4(2), pages 221-255, Summer.
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    Cited by:

    1. Manganelli, Simone & Wolswijk, Guido, 2007. "Market discipline, financial integration and fiscal rules: what drives spreads in the euro area government bond market?," Working Paper Series 745, European Central Bank.
    2. Hirshleifer, David & Teoh, Siew Hong, 2008. "Thought and Behavior Contagion in Capital Markets," MPRA Paper 9164, University Library of Munich, Germany.
    3. Jesse Russell, 2012. "Herding and the shifting determinants of exchange rate regime choice," Applied Economics, Taylor & Francis Journals, vol. 44(32), pages 4187-4197, November.
    4. Cipriani, Marco & Guarino, Antonio, 2008. "Transaction costs and informational cascades in financial markets," Journal of Economic Behavior & Organization, Elsevier, vol. 68(3-4), pages 581-592, December.
    5. Lillo, Felipe & Valdés, Rodrigo, 2016. "Dynamics of financial markets and transaction costs: A graph-based study," Research in International Business and Finance, Elsevier, vol. 38(C), pages 455-465.
    6. J. Ford & D. Kelsey & W. Pang, 2013. "Information and ambiguity: herd and contrarian behaviour in financial markets," Theory and Decision, Springer, vol. 75(1), pages 1-15, July.

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    More about this item

    Keywords

    Herd Behavior; Informational Cascades; Tobin Tax; Trade Costs;
    All these keywords.

    JEL classification:

    • C92 - Mathematical and Quantitative Methods - - Design of Experiments - - - Laboratory, Group Behavior
    • D8 - Microeconomics - - Information, Knowledge, and Uncertainty
    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading

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