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Informational Cascades with Endogenous Prices - The Role of Risk Aversion

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Informational Cascades with Endogenous Prices: the Role of Risk Aversion∗ Jean-Paul De´camps1, Stefano Lovo2 1 GREMAQ-IDEI, Universite´ de Toulouse 1, 21 Alle´e de Brienne, 31000 Toulouse, France, and Europlace Institute of Finance. 2 HEC School of Managment, Paris, and GRECHEC, 1 Rue de la Liberation, 78351, Jouy en Josas, France. Revised version: March 2005 Abstract. In this paper we show that long run market informational inefficiency and informational cascades can easily happen when trades occur at market clearing prices. We consider a sequential trade model where: (i) the investors’ set of actions is discrete; (ii) dealers and investors differ in risk aversion; (iii) investors’ information is bounded. We show that informational cascade occurs as soon as traders’ beliefs do not differ too sharply. Thus, prices cannot fully incorporate the private information dispersed in the economy. Keywords: Informational cascades, Endogenous Prices, Risk Aversion JEL Classification Numbers: G1, G14, D82, D83 ∗We thank an anonymous referee for providing comments that improved the exposition. Financial support from Europlace Institute of Finance is gratefully acknowledged. Corresponding author : S. Lovo. Tel: (33)(0)1 39 67 74 62; Fax: (33)(0)1 39 67 70 85; e-mail address: [email protected] 1 Introduction This last decade economists have made important progress in developing rational mod- els of herding and cascades that aim at explaining outcomes that at first glance appear anomalous. The seminal model of Bikhchandani, Hirshleifer and Welch (1992) (BHW henceforth) assumes that an investment opportunity is available to a series of investors at a fixed price. They show that rational investors can engage in imitative behavior leading to informational inefficiency, that is the failure in the aggregation of investors’ private information regarding the quality of the investment.1 BHW pioneered an im- pressive wealth of papers that helps us understand the basis for uniformity of behavior, informa

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