MULTIDIMENSIONAL UNCERTAINTY AND HERD BEHAVIOR IN FINANCIAL-MARKETS

We study the relationship between asset prices and herd behavior, whic h occurs when traders follow the trend in past trades. When traders ha ve private information on only a single dimension of uncertainty (the effect of a shock to the asset value), price adjustments prevent herd behavior. Herding arises when there are two dimensions of uncertainty (the existence and effect of a shock), but it need not distort prices because the market discounts the informativeness of trades during herd ing. With a third dimension of uncertainty (the quality of traders' in formation), herd behavior can lead to a significant, short-run mispric ing.(JEL G12, G14, D83, D84).