Herding and informational cascades – Theory and implications to financial markets

Abstract

This thesis discusses herding and informational cascades and their applications to the financial markets in the form of a literature review. The basic theories by Banerjee and Bikhchandani, Hirshleifer and Welch are introduced. I briefly study the consequences of herding and find out that the equilibrium is not always socially efficient. I analyze, under which assumptions do these models cause extensive herding and what can be done to prevent it. In the last chapter I present the key theories of herding in the financial markets and discuss their limitations. The main model is Avery and Zemsky’s model of multidimensional uncertainty. The main conclusion is that the rational herding models can be applied to financial markets, but herding is only possible under certain simplifying assumptions.