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Path-Dependent Behavior with Asymmetric Information about Traders' Types

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  • Testa, Alessia

Abstract

We define path-dependency as the generic phenomenon according to which agents take an action regardless of their private information. Path-dependency can be of two types contingent on whether agents act with the crowd (herding) or against the crowd (contrarianism). We consider a quote-driven market where traders can in some cases observe whether their predecessors were informed, although they cannot observe their private information, while in other cases they are left with the uncertainty that their predecessors acted purely for liquidity motives. In this setting we recover herding and contrarianism and we find that better-informed markets (i.e. where informed traders receive high precision signals) can generate path-dependent behavior more easily than poorly informed ones. Moreover, we illustrate how a market dominated by herding features a price that is more informative of the asset value than the price of a market where traders always follow their signal. We also discuss how contrarianism has the exact opposite effect by decreasing price informativeness.

Suggested Citation

  • Testa, Alessia, 2012. "Path-Dependent Behavior with Asymmetric Information about Traders' Types," Discussion Paper Series of SFB/TR 15 Governance and the Efficiency of Economic Systems 388, Free University of Berlin, Humboldt University of Berlin, University of Bonn, University of Mannheim, University of Munich.
    • Handle: RePEc:trf:wpaper:388
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    References listed on IDEAS

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    1. 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.
    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. Bikhchandani, Sushil & Hirshleifer, David & Welch, Ivo, 1992. "A Theory of Fads, Fashion, Custom, and Cultural Change in Informational Cascades," Journal of Political Economy, University of Chicago Press, vol. 100(5), pages 992-1026, October.
    4. Andreas Park & Hamid Sabourian, 2011. "Herding and Contrarian Behavior in Financial Markets," Econometrica, Econometric Society, vol. 79(4), pages 973-1026, July.
    5. Chamley,Christophe P., 2004. "Rational Herds," Cambridge Books, Cambridge University Press, number 9780521530927, October.
    6. Chamley,Christophe P., 2004. "Rational Herds," Cambridge Books, Cambridge University Press, number 9780521824019, October.
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    More about this item

    Keywords

    Herding; Contrarianism; Financial Markets;
    All these keywords.

    JEL classification:

    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
    • D83 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Search; Learning; Information and Knowledge; Communication; Belief; Unawareness
    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading

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