Rumors in Financial Markets Rumors in Financial Markets Insights into Behavioral Finance Mark Schindler Copyright © 2007 John Wiley & Sons Ltd, The Atrium, Southern Gate, Chichester, West Sussex PO19 8SQ, England Telephone (+44) 1243 779777 Email (for orders and customer service enquiries): cs-books@wiley.co.uk Visit our Home Page on www.wiley.com All Rights Reserved No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning or otherwise, except under the terms of the Copyright, Designs and Patents Act 1988 or under the terms of a licence issued by the Copyright Licensing Agency Ltd, 90 Tottenham Court Road, London W1T 4LP, UK, without the permission in writing of the Publisher Requests to the Publisher should be addressed to the Permissions Department, John Wiley & Sons Ltd, The Atrium, Southern Gate, Chichester, West Sussex PO19 8SQ, England, or emailed to 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Queensland 4064, Australia John Wiley & Sons (Asia) Pte Ltd, Clementi Loop #02-01, Jin Xing Distripark, Singapore 129809 John Wiley & Sons Canada Ltd, 6045 Freemont Blvd, Mississauga, ONT, L5R 4J3 Wiley also publishes its books in a variety of electronic formats Some content that appears in print may not be available in electronic books Anniversary Logo Design: Richard J Pacifico Library of Congress Cataloging in Publication Data Schindler, Mark Rumors in financial markets : insights into behavioral finance / Mark Schindler p cm ISBN-13: 978-0-470-03196-4 ISBN-10: 0-470-03196-4 Investments—Psychological aspects Investments—Decision making I Title HG4515.15.S35 2007 332.601 9—dc22 2006032510 British Library Cataloguing in Publication Data A catalogue record for this book is available from the British Library ISBN 978-0-470-03196-4 Typeset in 10/12pt Times by Integra Software Services Pvt Ltd, Pondicherry, India Printed and bound in Great Britain by TJ International, Padstow, Cornwall This book is printed on acid-free paper responsibly manufactured from sustainable forestry in which at least two trees are planted for each one used for paper production Contents List of Symbols ix Preface xi Introduction 1.1 Objectives of this book 1.2 Structure of this book 1.3 Research methodology Definitions and Characteristics of Rumors 2.1 Definitions 2.1.1 Structure of the categories, news, information and rumor 2.1.2 Rumors versus gossip 2.1.3 Summary of rumor characteristics 2.2 Historical background to studies on rumors 5 10 10 10 Rumors and the Theory of Finance 3.1 Rumors and Behavioral Finance 3.1.1 Theoretical excursion: A formal definition of the value of information 3.1.2 The relationship between the value of information and efficient markets 3.1.3 The criticisms of Behavioral Finance 3.1.4 The link between rumors and Behavioral Finance 3.1.5 Financial markets as a fruitful ground for rumors 3.1.6 Six types of rumors 3.1.7 Classification of rumors in financial markets 3.2 Rumors and rational behavior 3.2.1 Rationality in the classical Theory of Finance 3.2.2 Bounded rationality 3.2.3 Procedural rationality 3.2.4 An action is always rational 3.2.5 Rationality in financial markets 15 15 15 16 17 18 19 20 21 21 22 24 25 26 27 vi Rumors in Financial Markets 3.3 Empirical studies of rumors in the stock market 3.4 Review of models on rumors 3.5 Ethnographical studies 29 31 34 Legal Aspects of Rumors in Financial Markets 4.1 Rumors in financial markets and insider trading 4.1.1 Introduction 4.1.2 Review of scientific literature on insider trading 4.2 Review of models on insider trading 4.2.1 Models of insider trading regulation 4.2.2 Models of trading by registered insiders 4.3 Rumors in financial markets and price manipulation 4.4 Review of models on market manipulation 37 37 37 40 43 43 44 45 48 Survey of Rumors in Financial Markets 5.1 The survey and its intention 5.2 Participant profile 5.2.1 Survey parameters 5.2.2 Survey participants 5.3 Development of rumors 5.3.1 How rumors start and why 5.3.2 Correlation between market volatility and frequency of rumors 5.3.3 What is the source? 5.3.4 First actions on a rumor 5.3.5 Action on specific versus general rumors 5.4 Spreading of rumors 5.4.1 To spread or not to spread? 5.4.2 First or last in the row? 5.4.3 Spreading time: How long it takes 5.5 Belief in rumors 5.5.1 Why rumors are believed 5.5.2 Does it matter what you believe? 5.6 Network formation 5.7 Trading on rumors 5.7.1 Systematic price patterns? 5.7.2 Rumor sources and profits 5.7.3 Thoughts triggered by the price movement 5.7.4 Actions triggered by the price movement 5.8 Rumors versus information 5.8.1 Trading on rumors versus trading on information 5.8.2 The difference between a rumor and information 5.9 Conclusions from the survey 5.9.1 Rumors follow logical rules 5.9.2 Prices reflect beliefs 5.9.3 Investment strategies on rumors 5.9.4 Relating the results to other studies 51 51 51 51 52 53 53 56 57 58 59 59 59 60 61 63 63 65 66 69 69 69 70 72 73 73 74 75 75 76 77 78 Contents vii Rumor Experiments 6.1 Why use experiments as a research methodology? 6.2 Methodological pre-considerations 6.2.1 Internal versus external validity 6.2.2 Selection of participants 6.2.3 Payment of participants 6.3 Review of previous rumor experiments 6.3.1 The psychological experiments of DiFonzo and Bordia 6.3.2 An economic approach towards rumor experiments and their structuring in this book 6.4 First stage experiments: Ambiguity aversion in a financial market 6.4.1 A brief overview of ambiguity aversion 6.4.2 Experimental design 6.4.3 Results of the first stage experiments 6.4.4 Discussion 6.4.5 Conclusion 6.5 Second stage experiments: Varying rumor messages 6.5.1 A brief discussion of the existing literature 6.5.2 Experimental design 6.5.3 Results of the second stage experiments 6.5.4 Conclusion 6.6 Third stage experiments: Testing herd behavior 6.6.1 A brief overview of herd behavior in financial markets 6.6.2 Experimental design 6.6.3 Results of the third stage experiments 6.6.4 Discussion and conclusion 6.7 Fourth stage experiments: Communication 6.7.1 A brief overview 6.7.2 Experimental design 6.7.3 Results of the fourth stage experiments 6.7.4 Discussion and conclusion 84 85 86 96 98 101 105 106 106 108 109 113 113 114 121 122 127 128 128 129 130 137 Conclusions and Outlook 141 Appendices Appendix I Appendix I.1: Formal presentation of preference relations and choice rules Appendix I.2: Formal presentation of preference relations with utility functions Appendix II Appendix II.1: Experimental instructions for the rumor setting with an auctioneer (experiments and 2) Appendix II.2: Experimental instructions for the rumor setting with a batch auction (experiments and 4) Appendix II.3: Experimental instructions for the rumor setting in a continuous double auction (experiments to 12) 79 79 81 81 82 82 82 82 147 147 147 147 149 149 153 157 viii Rumors in Financial Markets Appendix III Appendix III.1: Second stage experimental instructions Appendix IV Appendix IV.1: Third stage experimental instructions Appendix V Appendix V.1: Fourth stage experimental instructions Appendix V.2: First two message levels 161 161 163 163 165 165 167 Notes 169 References 177 Index 191 List of Symbols t =0 T time periods s =1 S states of the world l =1 L lotteries x=1 X outcomes c s consequence of state s p s second-order probability of occurrence of state s u c s utility of consequence c in state s p s probability measure of occurrence of state s E p expectation with respect to the probability measure SEU x = s∈S ps u xs subjective expected utility qt stock price at time t dt dividend at time t .. .Rumors in Financial Markets Rumors in Financial Markets Insights into Behavioral Finance Mark Schindler Copyright © 2007 John Wiley & Sons Ltd, The Atrium, Southern... Congress Cataloging in Publication Data Schindler, Mark Rumors in financial markets : insights into behavioral finance / Mark Schindler p cm ISBN-13: 978-0-470-03196-4 ISBN-10: 0-470-03196-4 Investments—Psychological... Aspects of Rumors in Financial Markets 4.1 Rumors in financial markets and insider trading 4.1.1 Introduction 4.1.2 Review of scientific literature on insider trading 4.2 Review of models on insider