Ambiguity in financial markets: herding and contrarian behaviour

Abstract

The paper studies the impact of ambiguity on history-dependant beahviour in the standard microstructure model of financial markets. We show that differences in ambiguity attitudes between market makers and traders can generate contrarian and herding behaviour in stock markets where assets are traded sequentially and trading prices are endogenously determined. We also show the mispricing can be only short-term, and in the long-run market is efficient in the sense that the market price aggregates information without distortions.