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Herd Behavior and Contagion in Financial Markets

  • Marco Cipriani

    ()

    (Department of Economics/Institute for International Economic Policy, George Washington University)

  • Antonio Guarino

    ()

    (Department of Economics and ELSE, University College London)

We study a sequential trading financial market where there are gains from trade, i.e., where informed traders have heterogeneous private values. We show that an informational cascade (i.e., a complete blockage of information) arises and prices fail to aggregate information dispersed among traders. During an informational cascade, all traders with the same preferences choose the same action, either following the market (herding) or going against it (contrarianism). We also study financial contagion by extending our model to a two-asset economy. We show that informational cascades in one market can be generated by informational spillovers from the other. Such spillovers have pathological consequences, generating long-lasting misalignments between prices and fundamentals.

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File URL: http://www.gwu.edu/~iiep/assets/docs/papers/Cipriani_IIEPWP2008-19.pdf
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Paper provided by The George Washington University, Institute for International Economic Policy in its series Working Papers with number 2010-01.

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Length: 58 pages
Date of creation:
Publication status: Published in the B.E. Journal of Theoretical Economics, 8(1), Article 24, pp. 1-54, 2008
Handle: RePEc:gwi:wpaper:2010-01
Contact details of provider: Web page: http://www.gwu.edu/~iiep/
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