Fascinating Reading

Stochastic Herding in Financial Markets Evidence from Institutional Investor Equity Portfolios

by Makoto Nirei, Theodoros Stamatiou and Vladyslav Sushko

Working Papers No 371
February 2012

We estimate a structural model of herding behavior in which feedback arises due to mutual concerns of traders over the unobservable "true" level of market liquidity. In a herding regime, random shocks are exacerbated by endogenous feedback, producing a dampened power-law in the uctuation of largest sales. The key to the uctuation is that each trader responds not only to private information, but also to the aggregate behavior of others. Applying the model to the data on portfolios of institutional investors (fund managers), we nd that the empirical distribution is consistent with model predictions. A stock's realized illiquidity propagates herding and raises the probability of observing a sell-off. The distribution function itself has desirable properties for evaluating "tail risk".

JEL classi cation codes: C16, D8, G2, G14