Herd Behavior and Contagion in Financial Markets

We study a sequential trading financial market where there are gains from trade, that is, 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, 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.

[1]  John Geanakoplos,et al.  Leverage Cycles and the Anxious Economy , 2008 .

[2]  Sanford J. Grossman.  On the Impossibility of Informationally Efficient Markets , 1980 .

[3]  Paul R. Milgrom,et al.  Bid, ask and transaction prices in a specialist market with heterogeneously informed traders , 1985 .

[4]  J. Décamps,et al.  Informational cascades with endogenous prices: The role of risk aversion , 2006 .

[5]  G. Kaminsky,et al.  Currency and Banking Crises; The Early Warnings of Distress , 1999 .

[6]  P. Kehoe,et al.  On the robustness of herds , 2002 .

[8]  Marco Cipriani,et al.  Herd Behavior in a Laboratory Financial Market , 2005 .

[9]  Herd Behaviour in Efficient Financial Markets with Sequential Trades , 2005 .

[10]  Andrea Prat,et al.  Reputation and Asset Prices: A Theory of Information Cascades and Systematic Mispricing , 2005 .

[11]  Douglas Gale,et al.  What have we learned from social learning , 1996 .

[12]  James Dow,et al.  Informed Trading, Investment, and Welfare , 2003 .

[13]  L. Glosten.  Insider Trading, Liquidity, and the Role of the Monopolist Specialist , 1989 .

[14]  S. Bikhchandani,et al.  You have printed the following article : A Theory of Fads , Fashion , Custom , and Cultural Change as Informational Cascades , 2007 .

[15]  A. Velasco,et al.  Liquidity Crises in Emerging Markets: Theory and Policy , 1999, NBER Macroeconomics Annual.

[16]  Wei Xiong,et al.  Contagion as a Wealth Effect , 2001 .

[17]  Markus K. Brunnermeier.  Asset Pricing under Asymmetric Information , 2001 .

[18]  J. Doob.  Stochastic processes , 1953 .

[19]  Maureen O'Hara,et al.  PRICE, TRADE SIZE, AND INFORMATION IN SECURITIES MARKETS* , 1987 .

[20]  S. Titman,et al.  Momentum Investment Strategies, Portfolio Performance, and Herding: A Study of Mutual Fund Behavior , 1994 .

[21]  Paolo A. Pesenti,et al.  What Caused the Asian Currency and Financial Crisis? Part I: a Macroeconomic Overview , 1998 .

[22]  J. Mondria,et al.  Financial Contagion and Attention Allocation , 2006 .

[23]  Paul R. Masson,et al.  Contagion: Monsoonal Effects, Spillovers, and Jumps Between Multiple Equilibria , 1998 .

[24]  Franklin Allen,et al.  Optimal Financial Crises , 1998 .

[25]  Carmen M. Reinhart,et al.  On crises, contagion, and confusion , 2000 .

[26]  Nancy L. Stokey,et al.  Information, Trade, and Common Knowledge , 1982 .

[27]  S. Bikhchandani,et al.  Herd Behavior in Financial Markets: A Review , 2000, SSRN Electronic Journal.

[28]  Xavier Vives,et al.  Information and Learning in Markets , 2007 .

[29]  A. Park,et al.  When Herding and Contrarianism Foster Market Efficiency: A Financial Trading Experiment , 2008 .

[30]  G. Kaminsky,et al.  Currency and Banking Crises: The Early Warnings of Distress , 1998, SSRN Electronic Journal.

[31]  In Ho Lee.  Market Crashes and Informational Avalanches , 1998 .

[32]  Mathias Drehmann,et al.  Herding and Contrarian Behavior in Financial Markets: An Internet Experiment , 2005 .

[33]  J. Décamps,et al.  Market Informational Inefficiency, Risk Aversion and Quantity Grid , 2003 .

[34]  R. Sias.  Institutional Herding , 2002 .

[35]  Josef Lakonishok,et al.  The impact of institutional trading on stock prices , 1992 .

[36]  Kathy Yuan,et al.  Asymmetric Price Movements and Borrowing Constraints: A Rational Expectations Equilibrium Model of Crises, Contagion, and Confusion , 2005 .

[37]  Stacey L. Schreft,et al.  A Model of Financial Fragility , 2001, J. Econ. Theory.

[38]  R. Wermers,et al.  Mutual Fund Herding and the Impact on Stock Prices , 1998 .

[39]  Matthew Pritsker,et al.  A Rational Expectations Model of Financial Contagion , 1998 .

[40]  Patrick J. Kehoe,et al.  Financial Crises as Herds , 1999 .

[41]  Lones Smith,et al.  Pathological Outcomes of Observational Learning , 2000 .

[42]  G. Calvo,et al.  Contagion in Emerging Markets: When Wall Street is a carrier , 2004 .

[43]  D. Scharfstein,et al.  Herd Behavior and Investment , 1990 .

[44]  Marco Cipriani,et al.  Noise Trading in a Laboratory Financial Market: A Maximum Likelihood Approach , 2005 .

[45]  Charles M. Jones,et al.  Transactions, Volume, and Volatility , 1994 .

[46]  I. Welch.  Sequential Sales, Learning, and Cascades , 1992 .

[47]  Andreas Roider,et al.  Herding with and Without Payoff Externalities - an Internet Experiment , 2004 .

[48]  M. Eichenbaum,et al.  On the Fundamentals of Self-Fulfilling Speculative Attacks , 2000 .

[49]  Paolo A. Pesenti,et al.  Paper Tigers? a Model of the Asian Crisis , 1998 .

[50]  R. Rigobón,et al.  Currency crises and contagion: an introduction , 2002 .

[51]  Andrew Caplin,et al.  Sectoral Shocks, Learning, and Aggregate Fluctuations , 1993 .

[52]  Andrea Prat,et al.  Information aggregation in financial markets with career concerns , 2008, J. Econ. Theory.

[53]  M. King,et al.  Transmission of Volatility between Stock Markets , 1989 .

[54]  M. Cipriani,et al.  Transaction costs and informational cascades in financial markets , 2008 .

[55]  A. Banerjee,et al.  A Simple Model of Herd Behavior , 1992 .

[56]  S. Bikhchandani,et al.  Herd Behavior in Financial Markets; A Review , 2000 .

[57]  D. Hirshleifer,et al.  Herd Behaviour and Cascading in Capital Markets: A Review and Synthesis , 2003 .

[58]  C. Avery,et al.  Multidimensional Uncertainty and Herd Behavior in Financial Markets , 1998 .

[59]  Franklin Allen,et al.  Understanding Financial Crises , 2007 .

[60]  Douglas Gale,et al.  Information Revelation and Strategic Delay in a Model of Investment , 1994 .

[61]  Marco Cipriani,et al.  Herding and price convergence in a laboratory financial market , 2002 .

[62]  K. Arrow,et al.  The New Palgrave Dictionary of Economics , 2020 .

[63]  David Easley,et al.  One Day in the Life of a Very Common Stock , 1997 .

[64]  Marco Cipriani,et al.  Herd Behavior in Financial Markets: An Experiment with Financial Market Professionals , 2008 .