Informational Cascades with Endogenous Prices: the Role of Risk Aversion

In this paper we show that long run market informational ine¢ ciency and informational cascades can easily happen when trades occur at market clearing prices. We consider a sequential trade model where: (i) the investors’set of actions is discrete; (ii) dealers and investors di¤er in risk aversion; (iii) investors’information is bounded. We show that informational cascade occurs as soon as traders’beliefs do not di¤er too sharply. Thus, prices cannot fully incorporate the private information dispersed in the economy. Keywords: Informational cascades, Endogenous Prices, Risk Aversion JEL Classi…cation Numbers: G1, G14, D82, D83 We thank an anonymous referee for providing comments that improved the exposition. Financial support from Europlace Institute of Finance is gratefully acknowledged. Corresponding author : S. Lovo. Tel: (33)(0)1 39 67 74 62; Fax: (33)(0)1 39 67 70 85; e-mail address: [email protected]