Abstract
This paper provides a rational microstructure model in which informed traders have private information on multi-dimensional uncertainties and it is possible for the herd behavior to occur. In the herd phase, informed traders choose to trade in the same direction regardless of their private signals. In addition, we find that there always exists a transitional phase between the normal phase and the herd phase. The market enters a transition phase when some informed traders’ expectation on the risky asset value is within the bid-ask spread. In the transition phase, the market liquidity deteriorates, marked by larger spread and stronger price impact power of incoming orders. The research in the multiple markets situation shows that what happens in the transition phase in one market could affect not only that market but also related markets. It provides the stage for the market crash and the herd behavior to be contagious among multiple assets whose values are correlated.
Highlights
The history of financial markets is punctuated with menacing market crashes
In this paper we develop a rational model explaining the mechanism of market crash and the herd behavior in financial markets
We find a transition phase exists between the normal phase and the herd phase
Summary
The history of financial markets is punctuated with menacing market crashes. In order to explain market crash mechanisms, the theory of herd behavior and informational cascade have been widely exploited by scholars. Facing the income sell order, the market maker will place more weights on both the possibility of a strong-negative signal and the possibility of a weak-negative signal Enhancing the latter belief will produce larger downward price pressure than the former since the asset value is definitely low with a negative perfect signal. If it is true that the perfect-signaled component is in the low state, the price will remain stable at the low level because every informed trader receives a strong-negative signal and knows that the final asset payoff is low. If the market maker puts too much weight on the belief that of the perfect-signaled component is in the low state, which is not the truth here, and set the price too low, the informed trader’s expectation of the asset value could be higher than the market price even if he receives a weak-negative signal.
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