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Herd Behavior and Contagion in Financial Markets

Author

Listed:
  • Marco Cipriani

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

  • Antonio Guarino

    (Department of Economics and ELSE, University College London)

Abstract

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.

Suggested Citation

  • Marco Cipriani & Antonio Guarino, 2010. "Herd Behavior and Contagion in Financial Markets," Working Papers 2010-01, The George Washington University, Institute for International Economic Policy.
    • Handle: RePEc:gwi:wpaper:2010-01
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    JEL classification:

    • D8 - Microeconomics - - Information, Knowledge, and Uncertainty
    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading

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