Sunday, May 16, 2010

A Rum Thing

Guest post by Stephen Hogg

This Business Spectator article gave me pause for thought. It is discusses how ASIC recently made a ham-fisted attempt at reigning in rogues in the market making a buck off spreading a rumour and then profiting from inevitable price movements. It’s called rumourtrage, and is the practice of spreading false or misleading information in respect of securities in order to take advantage of artificial changes in market prices.

Now don’t get me wrong, it’s a cunning idea. I know a lot of people who wish they had thought of it some years ago. But I became stuck on one point made by ASIC. At the end of the article it is made plain that when ASIC was figuring out how to put a stop to all this, that:

"The principles were developed noting concerns that confidence in the integrity of Australia’s markets could be undermined if investors believe rumours are actively spread in the market to distort proper price discovery"

I think is a flawed statement.

Let’s go back a step or two, and revisit the Modigliani-Miller theorem (which everyone conveniently forgot about until a year or so ago!). The theorem predicts that in a world of perfect information, the choice to fund your company with debt or equity won’t change its value. The same theorem leads us to the conclusion that with perfect information, the share price of a firm reflects all the information regarding that firm – a pretty well-known result!

“The basic theorem states that, under a certain market price process (the classical random walk), in the absence of taxes, bankruptcy costs, and asymmetric information, and in an efficient market, the value of a firm is unaffected by how that firm is financed. It does not matter if the firm's capital is raised by issuing stock or selling debt. It does not matter what the firm's dividend policy is. Therefore, the Modigliani-Miller theorem is also often called the capital structure irrelevance principle.”

However, full information is absolute insanity. There are heaps of things we don’t know. For example, I would pay dearly to know what Andrew Forrest, CEO of Fortescue Metals, was thinking when he described his knock-down drag-out conversation (read: argument) with Ken Henry at the National Press Club last Tuesday as “delightful” to a pack of journalists afterwards. I’m pretty sure that if that tidbit was common knowledge the share price of Fortescue would be significantly different to what it is at the moment.

So in this world of imperfect information what does the share price of a company reflect? Not much, unfortunately. All you can really get out of it is the appetite for risk of the average punter which, when you put it on a chart, appears to go up in a boom and down in a bust. Seems logical enough.

Which brings me back to the problem with ASIC’s latest piece of work. If the prices of shares don’t really reflect anything at all aside from the appetite for risk of the average individual in the market, why on earth take on the Sisyphean task of making sure that price signals are representative of the shape a given company is in? There’s a far bigger problem at work here, which ASIC doesn’t appear to be focussed on. It is the welfare transfer which occurs because of rumourtrage.

Because of the ability to distort the perceptions of others regarding the state of the market and the general willingness of the participants to take on risk, a welfare transfer occurs, from the rumour monger to the rumour believer, which otherwise would not have. That’s the thing which needs to be sorted out here – which means unwinding selected trades rather than adjusting the share price for all trades, including those not subject to rumourtrage.


  1. Even if the value of the whole company is the same under that theorem, the value of each share would change if a rumour suggested there might be a dilution of ownership (or some such thing).

    Also, how to you suppose ASIC could 'unwind' selected trades? How would anyone know who started a rumour? Isn't an uncertain source a feature of a rumour?

  2. Hello!

    That comment also misses the point - we aren't in a world where the optimal result can be obtained. Instead, we have to address the matter as best we can, by only dealing with selected trades as against the market as a whole (which admittedly is affected). While this is an imperfect solution, it generates a smaller loss in welfare as an attempt to remedy the situation than resetting the price level would.

    As far as finding out who starts these rumours, read the original article. The guidelines are built around confidential information handling, so in this case we have a fair idea of who the culprits are.