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Risk Aversion and Herd Behavior in Financial Markets

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HerdShort3.dvi Risk Aversion and Herd Behavior in Financial Markets � Jean-Paul DECAMPS y and Stefano LOVO z May 9, 2003 Abstract We show that di�erences in market participants risk aversion can generate herd behavior in stock markets where assets are traded sequentially. This in turn prevents learning of market's fundamentals. These results are obtained without introducing multidimensional uncertainty or transaction cost. (JEL: G1, G14, C11, D82) Keywords: Herd Behavior, Risk Aversion. 1 Introduction The literature on rational herding pioneering by Bikhchandani, Hirshleifer and Welch (1992) and Banerjee (1992) among others, proves that sequential interaction of rational investors can generate imitative behavior (herding) that prevents learning of the econ- omy's fundamentals. However, in the herding models transaction prices are exogenous and constant, therefore their predictions cannot be directly extended to stock markets. To what extent the endogeneity of trading prices in �nancial markets can prevent herding phenomena and guarantee full information aggregation? Avery and Zemsky (1998) (AZ henceforth) and Lee (1998) study the occurrence of herding in stock markets when trading is sequential and prices are endogenous. AZ show that the presence of multidimensional uncertainty, in the short run can generate herd behavior as well as large di�erences between an asset's trading price and its funda- mental value. Nevertheless, in the long run all these phenomena vanish and all private � We would like to thank Bruno Biais, Cristophe Chamley, Thierry Foucault, Christian Gollier and Jacques Olivier for insightful conversation and valuable advice. We would also like to thank the seminar participants at HEC, CentER and Cergy Pontoise University for useful comments and suggestions. Of course all errors and omissions are ours. y GREMAQ-IDEI Universit�e de Toulouse 1, 21 Allee de Brienne, 31000 Toulouse, France, e-mail: [email protected]

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