Path-dependent behavior and information leakage in financial markets

Abstract

I develop a new mechanism that exploits the leakage of information in financial markets to deliver herding and contrarian behavior, which I label “path-dependent behavior.” The mechanism is related to the role of word-of-mouth communication in transmitting information about stocks among traders. In practice, this occurs via dealing interactions and a notable phenomenon called “the broker’s ear.” I find that, for a suitably long trading history, path-dependent behavior is more likely the better the quality of traders’ private information. Herding in the direction of the true state of the world occurs almost surely for any initial beliefs, and it improves price informativeness. An external observer who underestimates/overestimates the rate of information leakage will always overestimate/underestimate the quality of private information. I also show that when the quality of private information is very high and the asymmetry of information between traders and market maker is pronounced, the market is expected to herd 50% of the time. Nonetheless, this has little impact on order imbalance, excluding cases exhibiting catastrophic price behavior.