Abstract

This paper provides a rational microstructure model in which informed traders have private information on multi-dimensional uncertainties and it is possible for the herd behavior to occur. In the herd phase, informed traders choose to trade in the same direction regardless of their private signals. In addition, we find that there always exists a transitional phase between the normal phase and the herd phase. The market enters a transition phase when some informed traders’ expectation on the risky asset value is within the bid-ask spread. In the transition phase, the market liquidity deteriorates, marked by larger spread and stronger price impact power of incoming orders. The research in the multiple markets situation shows that what happens in the transition phase in one market could affect not only that market but also related markets. It provides the stage for the market crash and the herd behavior to be contagious among multiple assets whose values are correlated.

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