Behavioral Finance Lecture 4 - Herd Behavior: Informational Externalities

Teaching Goals
Graphical Description of the Model

Algebraic Description of the Model
Application: Herding among Foreign Exchange Forecasters
Behavioral Finance
Lecture 4 - Herd Behavior: Informational Externalities
Dr. Markus Demary
Ulm University
Summer Term 2021
Dr. Markus Demary Behavioral Finance

Teaching Goals
1 Teaching Goals
1 Graphical Description of the Model
1 Algebraic Description of the Model

Assumptions
Individual Decisions
Multiple Signals
Observing the Actions of Others
Lessons from the Cascade Model
1 Application: Herding among Foreign Exchange Forecasters

Application to Forecasting

Empirical Results of Pierdzioch and Stadtmann (2010)

Teaching Goals
1 Teaching Goals

Assumptions
Multiple Signals



Teaching Goals
Informational Externalities
Teaching goals: you should learn
∙ the basics of observational learning / Bayesian learning

∙ in which situations it is optimal for agents to neglect their own information
and follow the herd
∙ that information revelation can break down in sequential decisions
The Model of Bikhchandani, Hishleifer and Welch (1992)1
∙ informational cascades can occur in sequential models with fixed prices
The Model of Avery and Zemsky (1998)
∙ informational cascades cannot occur in sequential models with flexible

prices
1
We use the description of informational cascades from the textbook Easley and Kleinberg
(2010): ”Networks, Crowds and Markets: Reasoning about a Highly Connected World”, Cambridge
University Press.
Teaching Goals
1 Teaching Goals

Assumptions
Multiple Signals



Teaching Goals
1 Teaching Goals

Assumptions
Multiple Signals



Teaching Goals
Bayesian learning (I)

Easley and Kleinberg (2010)
Tested
positive 19
20
Infectious
Tested 1
negative
1000
Tested
positive 49
Non-
infectious
980
Tested 931
negative
Teaching Goals
Bayesian learning (II)

High signal
300
500
Good state
200
Low signal
1000
High signal
200
Bad state
500
Low signal 300

Teaching Goals
Bayesian learning (III)

High signal
0.6
0.5
Good state
0.4
Low signal
Asset
High signal
0.4
Bad state
0.5
Low signal 0.6

Teaching Goals
An Informational Cascade Occurs (I)

Positive Signal
adopt
adopt Third Agent
Positive Signal
reject
adopt Second Agent
reject Third Agent

First Agent
Negative
Signal
reject Second Agent
Negative
Signal
Teaching Goals
An Informational Cascade Occurs (II)

First Agent High signal adopt Second Agent
High signal indicates

that adopting is a
good idea

Teaching Goals
An Informational Cascade Occurs (III)

High signal adopt
First Agent High signal adopt Second Agent
High signal indicates Second agent has access

that adopting is a to two high signals
good idea

Teaching Goals
An Informational Cascade Occurs (IV)

First Agent High signal adopt Second Agent indifferent
Low signal
High signal indicates Second agent has access

that adopting is a to two different signals
good idea

Teaching Goals
An Informational Cascade Occurs

1
0.5 High signal adopt
(high , high) adopt
Second Agent Third Agent

0.5
adopt
(high, low)
0.5
If the second agent has
reject adopted, the thrid agent
0.5
infers 3 positive signals.
Adopting given high
signal is more likely
than adopting
given low signal.

Teaching Goals
1 Teaching Goals

Assumptions
Multiple Signals



Teaching Goals
1 Teaching Goals

Assumptions
Multiple Signals



Teaching Goals
1 Teaching Goals

Assumptions
Multiple Signals



Teaching Goals
Assumptions (I)
Sequential decision process

Information acquisition through
∙ own private signal
∙ actions of predecessors (which indicate their private signals)
observable and hidden information

∙ actions from predecessors are observable
∙ signals on which actions were based are unobservable

Teaching Goals
Assumptions (II)
1. Choices
∙ accept option
∙ reject option
2. States of the world

The state of the world is chosen randomly by nature and cannot be observed by any agent.
However, agents know the prior probabilities of any state to occur
∙ state G: adopting is a good idea, with prior probability 1/2
∙ state B: adopting is a bad idea, with prior probability 1/2
3. Payoffs
Each individual receives a payoff based on the decision to accept or reject the option
∙ accept:
∙ accepting was a good idea: payoff = +1
∙ accepting was a bad idea: payoff = -1
∙ reject: payoff = 0
We also assume that before the agents get any additional information, the expected payoff from
accepting is equal to the payoff from rejecting.
Teaching Goals
Assumptions (III)
4. Private information
Each agent gets a private signal that provides information about whether accepting is a good idea
or a bad idea
good state G bad state B

high signal H q > 1/2 1-q < 1/2
low signal L 1-q < 1/2 q > 1/2
The private signal does not provide certainty, but it conveys useful information
∙ high signals H suggest that accepting is a good idea
∙ low signals L suggest that accepting is a bad idea
Inferring information from signals
∙ accepting is a good idea, when high signal indicates good state

∙ accepting is a bad idea, when low signal indicates bad state

Teaching Goals
1 Teaching Goals

Assumptions
Multiple Signals



Teaching Goals
1 Teaching Goals

Assumptions
Multiple Signals



Teaching Goals
Expected payoff before observing the private signal
payoff = P (G) · 1 + P (B) · (−1) = 0.5 · 1 + 0.5 · (−1) = 0 (1)
Expected payoff after observing the private signal H
∙ Suppose that the agent gets the high signal H but does not observe the others’ actions.
Then the agent’s payoff is
payoff = P (G|H) · 1 + P (B|H) · (−1) (2)
∙ The posteriors are calculated according to Bayes’ rule
P (G) · P (H|G) P (G) · P (H|G)
P (G|H) = = (3)
P (H) P (G) · P (H|G) + P (B) · P (H|B)
0.5q
= = q > 0.5 (4)
0.5q + 0.5(1 − q)
∙ expected payoff shifts from 0 to positive number
payoff = P (G|H) · 1 + P (B|H) · (−1) = q · 1 + (1 − q) · (−1) = 2q − 1 > 0 (5)
∙ hence, the agent should accept the option

Teaching Goals
1 Teaching Goals

Assumptions
Multiple Signals



Teaching Goals
1 Teaching Goals

Assumptions
Multiple Signals



Teaching Goals
Multiple Signals
Bayesian rule for multiple signals
P (H|G)P (G)
P (G|H) = (6)
P (H|G)P (G) + P (H|B)P (B)
P (H|G)P (G|H)
P (G|HH) = (7)
P (H|G)P (G|H) + P (H|B)P (B|H)
P (H|G)P (G|HH)
P (G|HHH) = (8)
P (H|G)P (G|HH) + P (H|B)P (B|HH)
P (H|G)3 P (G)
= (9)
P (H|G)3 P (G) + P (H|B)3 P (B)
General Bayesian rule
P (H|G)a P (L|G)b P (G)

P (G|a = #H, b = #L) = (10)
P (H|G)a P (L|G)b P (G) + P (H|B)a P (L|B)b P (B)
q a (1 − q)b 0.5
= (11)
q a (1 − q b )0.5 + (1 − q)a q b 0.5

Teaching Goals
1 Teaching Goals

Assumptions
Multiple Signals



Teaching Goals
1 Teaching Goals

Assumptions
Multiple Signals



Teaching Goals

Observable and unobservable information
∙ agents observe what others do (actions)

∙ agents cannot observe what others know (signals)
∙ agent has access to his or her private signal and to the accept/reject decisions of all earlier
agents
Trade imbalance
∙ the trade imbalance at time t is defined as the number of buy orders a minus the number of
sell orders b until time t − 1
∙ it is based on the number of observable actions of the predecessors a + b
Result 1: Bikchandani et al. 1992
∙ When the asset price is fixed an informational cascade occurs after a trade imbalance of
a − b ≥ 2 or a − b ≤ −2.
Result 2: Avery and Zemsky 1998
∙ When the market maker sets the asset price agents always trade according to their private
signal and an informational cascade cannot occur.
Teaching Goals
1 Teaching Goals

Assumptions
Multiple Signals



Teaching Goals
1 Teaching Goals

Assumptions
Multiple Signals



Teaching Goals

Cascades can be wrong
∙ if accepting the option is a bad idea but the first two agents get high signals
∙ a cascade of acceptances will start immediately even though it is the wrong choice
Cascades can be based on very little information
∙ people ignore their private information once a cascade stats

∙ hence, only the pre-cascade information influences the agents’ decisions
∙ most of the private information in the form of private signals is not used
Cascades are fragile
∙ cascades are easy to start since they are based on little information
∙ agent who receive superior information can overturn cascades

Teaching Goals
1 Teaching Goals

Assumptions
Multiple Signals



Teaching Goals
1 Teaching Goals

Assumptions
Multiple Signals



Teaching Goals
1 Teaching Goals

Assumptions
Multiple Signals



Teaching Goals
Application to Forecasting (I)

Pierdzioch and Stadtmann (2010)
Pierdzioch and Stadtmann (2010) apply the model of Bikhchandani et al.

(1993) to foreign exchange forecasters
Model transformation
∙ option: exchange rate forecast published by forecasters
∙ private signal: forecasters own research
∙ public actions: published forecasts of other institutes
∙ payoff = 1 if prediction was precise (e.g. gain in reputation)
∙ payoff = -1 if prediction was unprecise (e.g. loss in reputation)
Used dataset
∙ exchange rate forecasts published monthly by Consensus Economics Inc.
∙ USD-GBP and USD-EUR exchange rates in monthly frequency

Teaching Goals
Application to Forecasting (II)

Pierdzioch and Stadtmann (2010) analyse forecasts of the following institutes:

List of forecasters
USD/GBP USD/EUR
ABN Amro HSBC ABN Amro Imperial Chemical
Bank of America Imperial Chemics Allianz Industrial Bank of Japan
Bank of Tokio Industrial Bank of Japan Bank of America ING Barings
Bankers Trust ING Barings Bank of Tokio JP Morgan
BNP - Banque National de Paris JP Morgan Barclays Bank Merrill Lynch
Barclays Bank Merrill Lynch Barclays Capital Morgan Stanley
Barkleys Capital Morgan Stanley BNP Paribas Nat West Group
Allianz NatWest Group Chase Manhattan Nomura Research Institute
Chase Manhattan Oxford Econ Forecasting Citigroup Oxford Econ Forecasting
Citibank SSB Royal Bank of Canada Commerzbank Royal Bank of Canada
Commerzbank Societe Generale Credit Suisse Royal Bank of Scotland
Credit Suisse Standard Chartered Bank Deutsche Bank Societe General
Deutsche Bank UBS Warburg Dillon Read Dresdner Bank Standard Chartered Bank
Dresdner Bank Westdeutsche Bank General Motors UBS Warburg
General Motors Nomura Securities Global Insight WestLB
Global Insight Royal Bank of Scotland HSBC
Source: Pierdzioch and Stadtmann (2010)

Teaching Goals
Application to Forecasting (III)

Individual forecasts and consensus forecast
∙ Et,i [st+1 ]: individual forecast of the exchange rate of the next month
PN
∙ E t [st+1 ] = 1
N Et,i [st+1 ]: consensus forecast
i=1
∙ st+1 < Et,i [st+1 ]: individual forecast overpredicts the exchange rate
∙ Et,i [st+1 ] > E t [st+1 ]: individual forecast higher than the consensus forecast
Probability of overprediction
∙ P (Et,i [st+1 ] > st+1 |Et,i [st+1 ] > E t [st+1 ]) = 0.5: no herding
∙ P (Et,i [st+1 ] > st+1 |Et,i [st+1 ] > E t [st+1 ]) < 0.5: herding
∙ P (Et,i [st+1 ] > st+1 |Et,i [st+1 ] > E t [st+1 ]) > 0.5: anti-herding
Probability of underprediction
∙ P (Et,i [st+1 ] < st+1 |Et,i [st+1 ] < E t [st+1 ]) = 0.5: no herding
∙ P (Et,i [st+1 ] < st+1 |Et,i [st+1 ] < E t [st+1 ]) < 0.5: herding
∙ P (Et,i [st+1 ] < st+1 |Et,i [st+1 ] < E t [st+1 ]) > 0.5: anti-herding
Teaching Goals
1 Teaching Goals

Assumptions
Multiple Signals



Teaching Goals
1 Teaching Goals

Assumptions
Multiple Signals



Teaching Goals
1 Teaching Goals

Assumptions
Multiple Signals



Teaching Goals
Empirical Results of Pierdzioch and Stadtmann (2010) (I)

Empirical Analysis for USD-GBP
1 month ahead prediction Forecast < Cons. Forecast Forecast > Cons. Forecast
Exchange Rate < Forecast 28.8% 63.0%
Exchange Rate > Forecast 71.2% 37.0%
S-Statistic 0.6707 (0.0128)
S-Statistic 0.6701 (0.0126)
1 month ahead prediction Forecast < Cons.Forecast Forecast > Cons. Forecast
S-Statistic 0.6136 (0.0129)
Results
∙ P (st+1 < Ei,t [st+1 ]|Ei,t [st+1 ] > Et [st+1 ]) > 0.5 −→ Anti-Herding
∙ P (st+1 > Ei,t [st+1 ]|Ei,t [st+1 ] < Et [st+1 ]) > 0.5 −→ Anti-Herding

Teaching Goals
Empirical Results of Pierdzioch and Stadtmann (2010) (II)

Empirical Analysis for USD-EUR
S-Statistic 0.6812 (0.0101)
S-Statistic 0.6494 (0.0100)
1 month ahead prediction Forecast < Cons.Forecast Forecast > Cons. Forecast
S-Statistic 0.6472 (0.0103)
Results
∙ P (st+1 < Ei,t [st+1 ]|Ei,t [st+1 ] > Et [st+1 ]) > 0.5 −→ Anti-Herding
∙ P (st+1 > Ei,t [st+1 ]|Ei,t [st+1 ] < Et [st+1 ]) > 0.5 −→ Anti-Herding

Teaching Goals
Empirical Results of Pierdzioch and Stadtmann (2010) (III)

Results
∙ no empirical evidence for herding but for anti-herding among professional
foreign exchange forecasters
∙ maybe they want to separate from the consensus forecast in order to signal
private information
∙ forecaster tries to be the ”super-star”: does not want to share success with
other forecasters
Next lectures
∙ herding through payoff-externalities
∙ reputational herding
∙ empirical evidence from herding experiments

Behavioral Finance Lecture 4 - Herd Behavior: Informational Externalities

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Teaching Goals

Graphical Description of the Model

Lecture 4 - Herd Behavior: Informational Externalities

Dr. Markus Demary

Summer Term 2021

Dr. Markus Demary Behavioral Finance

1 Graphical Description of the Model

1 Algebraic Description of the Model

1 Application: Herding among Foreign Exchange Forecasters

1 Application: Herding among Foreign Exchange Forecasters

Dr. Markus Demary Behavioral Finance

1 Graphical Description of the Model

1 Algebraic Description of the Model

1 Application: Herding among Foreign Exchange Forecasters

1 Application: Herding among Foreign Exchange Forecasters

Dr. Markus Demary Behavioral Finance

Teaching goals: you should learn

∙ the basics of observational learning / Bayesian learning

The Model of Bikhchandani, Hishleifer and Welch (1992)1

∙ informational cascades can occur in sequential models with ﬁxed prices

The Model of Avery and Zemsky (1998)

∙ informational cascades cannot occur in sequential models with ﬂexible

1 Graphical Description of the Model

1 Algebraic Description of the Model

1 Application: Herding among Foreign Exchange Forecasters

1 Application: Herding among Foreign Exchange Forecasters

Dr. Markus Demary Behavioral Finance

1 Graphical Description of the Model

1 Algebraic Description of the Model

1 Application: Herding among Foreign Exchange Forecasters

1 Application: Herding among Foreign Exchange Forecasters

Dr. Markus Demary Behavioral Finance

Bayesian learning (I)

Bayesian learning (II)

Low signal 300

Bayesian learning (III)

Low signal 0.6

An Informational Cascade Occurs (I)

adopt Third Agent

adopt Second Agent

reject Third Agent

reject Second Agent

An Informational Cascade Occurs (II)

First Agent High signal adopt Second Agent

High signal indicates

Dr. Markus Demary Behavioral Finance

An Informational Cascade Occurs (III)

High signal adopt

First Agent High signal adopt Second Agent

High signal indicates Second agent has access

Dr. Markus Demary Behavioral Finance

An Informational Cascade Occurs (IV)

First Agent High signal adopt Second Agent indifferent

High signal indicates Second agent has access

Dr. Markus Demary Behavioral Finance

An Informational Cascade Occurs

Second Agent Third Agent

Dr. Markus Demary Behavioral Finance

1 Graphical Description of the Model

1 Algebraic Description of the Model

1 Application: Herding among Foreign Exchange Forecasters

1 Application: Herding among Foreign Exchange Forecasters