Stock Market Bubble and Herding

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Herding is an everyday phenomenon from personal to financial contexts. The focus of this paper is to explore the theory of herding, namely Compensation Based Herding (CBH) and its effect on financial markets. The report aims to explain herding, assess the advantages and disadvantages of CBH incorporating the 2008 financial crisis, and explore the possibility that CBH may have no effect on the financial markets. Herding occurs when investors imitate each other and create a bandwagon effect. There are three general reasons why herding exists in financial markets. Firstly it is due to uncertainty, where if investors are unsure of the markets, they will simply mimic each other’s actions. Secondly, agents are compensated in relation to the…show more content…
An example of CBH can be seen in the 2008 financial system crisis. Investment banks began to emulate each other through a period of high volumes of sub-prime mortgages. The demand for sub-prime mortgages was rising as hopeful home owners with poor credit could obtain such a mortgage by paying little or no down payment and without going through proper tax documentation and credit checks. Investment banks borrowed more to purchase the sub-prime mortgages and earned a commission fee when selling it to individuals and institutions. Decisions made across the investment banks began to become more uniform, as these investors were compensated based on their performance measured against their peers. Investment banks were making large profits, cashing in on the notion that as the demand for the sub-prime mortgages and houses went up, the house prices increased in accordance. If the mortgage holders were to default, their houses were worth enough to cover their debts with the banks. However, they were ignoring the blatant evidence that their investment portfolios were inefficient and highly risky. Publicly available information showed that these mortgage holders were not able to meet their payments. Not only were their credit ratings exceptionally low as compared to other borrowers, these sub-prime mortgages also carry interest rate structures with low “teaser rates” in the first few
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