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Multi-dimensional uncertainty and herd behavior in financial markets

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The authors study the relationship rational behavior and asset prices. They define herd behavior as accurring when an agent trades against his initial assessment and instead follows the trend in previous trade. When tradders have an informational advantage on a single dimension (the new asset value), price adjustements by a competitive market maker prevent any herd behavior. If the market maker is additionallu uncertain as to whether the underlying asset value has changed, the authors show that herd behavior is possible. However, such herd behavior need not affect the asset price because the market correctly discounts the informativeness of trades during periods of herding. When the market is uncertain about both whether the asset value has changed and whether traders are well or poorly informed on average about the new asset value, then herd behavior can lead to significant, short-run price movements that do not reflect the true asset value.

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en

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application/pdf

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http://flora.insead.edu/fichiersti_wp/inseadwp1996/96-79.pdf

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Copyright INSEAD. All rights reserved