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Herd Behavior and Contagion in Financial Markets

Author

Listed:
  • Cipriani Marco

    (George Washington University and IMF, marco.cipriani@gwu.edu)

  • Guarino Antonio

    (University College London, a.guarino@ucl.ac.uk)

Abstract

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.

Suggested Citation

  • Cipriani Marco & Guarino Antonio, 2008. "Herd Behavior and Contagion in Financial Markets," The B.E. Journal of Theoretical Economics, De Gruyter, vol. 8(1), pages 1-56, October.
    • Handle: RePEc:bpj:bejtec:v:8:y:2008:i:1:n:24
    DOI: 10.2202/1935-1704.1390
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    More about this item

    Keywords

    herd behavior; financial contagion; social learning; informational cascades; financial crises;
    All these keywords.

    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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