Browsing by Author "Haapanen, Anna"

The latest financial crisis stimulated discussions about the necessity of updating some of the asset pricing and financial market models. Rational herding of investors is one possible way to approach this problem. Especially, in the times of increased uncertainty investors are more easily affected by the actions of others, trying to protect their income or status. Furthermore, herding is frequently associated with a destabilizing effect on trading prices in the financial markets. The thesis has two main goals. Firstly, it theoretically establishes necessary conditions that stimulate rational herding among the investors in the financial markets. The main focus is on the significance of the increase of uncertainty. Secondly, it studies how rational herding might increase price volatility and lead to price bubbles. The thesis introduces two sequential trading models with rational herd behaviour. The models are closely linked to the main themes. The model by Avery and Zemsky (1998) focuses on the influence of the multidimensionality of uncertainty in the financial markets and presents it as a main reason for investors’ herding behaviour. The model also introduces a mechanism through which herding may lead to price bubbles. Avery and Zemsky (1998) achieve price bubbles by the addition of a third dimension of uncertainty. The second model is by Park and Sabourian (2011). It underlines the effect the form of the signal has on the behaviour of the investors and establishes more profound arguments for the appearance of price bubbles in the financial markets due to herding. The main conclusion of the thesis is that theoretically it is relatively easy to confirm that the increase of uncertainty in the financial markets, for example due to a financial crisis, can lead to herd behaviour of rational investors. Another important conclusion is that it can be theoretically established that herding increases price volatility and might even partly explain the phenomenon of price bubbles. The findings of the thesis suggest that rational herding should be considered as a possible extension to the financial market and pricing models, which currently govern policymakers’ decision-making processes.