Asset Pricing under Asymmetric Information: Bubbles, Crashes, Technical Analysis, and Herding

The last chapter illustrated herding and informational cascades in a general context. This chapter shows that herding can also arise in financial markets and describes how herding behavior can be used to explain interesting empirical observations in finance. For example, herding can result in stock market crashes and frenzies in auctions. The stock market might still be rising prior to a crash if bad news is hidden and not reflected in the price. A triggering event can reveal this hidden news and lead to a stock market crash. Crashes and frenzies in auctions are described in greater detail in Section 6.1.3 .

Another example is the use of investigative herding models to show that traders have a strong incentive to gather the same short-run information. Trading based only on short-run information guarantees that the information is reflected in the price early enough before traders unwind their acquired positions. Section 6.2 illustrates the different reasons why traders might want to unwind their positions early and highlights the limits of arbitrage. It also throws new light on Keynes' comparison of the stock market with a beauty contest.

This short-run focus of investors not only affects the stock price but can also potentially affect corporate decision making. In Section 6.3 we cover two models which show that if investors focus on the short-run, and if corporate managers care about the stock market value, then corporate decision making also becomes short-sighted.

Finally, bank run models are closely linked to herding models. Seminal bank run papers are presented in Section 6.4 . While the early papers did not appeal to herding models directly, this connection is explicitly drawn in the more recent research on bank runs. Insights from the bank run literature can also help us get a better understanding of international financial crises. For example, the financial crisis in Southeast Asia in the late 1990s is often viewed as a big bank run.

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