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Multidimensional Uncertainty and Herd Behavior in Financial Markets

Christopher Avery and Peter Zemsky

American Economic Review, 1998, vol. 88, issue 4, 724-48

Abstract: The authors study the relationship between asset prices and herd behavior, which occurs when traders follow the trend in past trades. When traders have private information on only a single dimension of uncertainty (the effect of a shock to the asset value), price adjustments prevent herd behavior. Herding arises when there are two dimensions of uncertainty (the existence and effect of a shock), but it need not distort prices because the market discounts the informativeness of trades during herding. With a third dimension of uncertainty (the quality of traders' information), herd behavior can lead to a significant, short-run mispricing. Copyright 1998 by American Economic Association.

Date: 1998
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Handle: RePEc:aea:aecrev:v:88:y:1998:i:4:p:724-48