Herding in Finance, Stock Market Crashes, Frenzies, and Bank Runs
This chapter shows that herding can help to explain many empirical phenomena in finance, like stock market crashes. In a setting with widely dispersed information, even relatively unimportant news can lead to large price swings and crashes. Stock market crashes can also occur because of liquidity problems, bursting bubbles, and sunspots. Traders might also herd in information acquisition if they care about the short‐term price path as well as about the long‐run fundamental value. Under these circumstances all traders will try to gather the same piece of information. These models also provide a deeper understanding of Keynes’ comparison of the stock market with a beauty contest. Limits to arbitrage are discussed and it is shown that if investors focus on the short‐run, corporate decision‐making also becomes shortsighted. The chapter concludes with a brief summary of bank runs and its connection to financial crises.
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