Rumors in Financial Markets

1 Introduction 1

1.1 Objectives of this book 2

1.2 Structure of this book 3

1.3 Research methodology 4

2 Definitions and Characteristics of Rumors 5

2.1 Definitions 5

2.1.1 Structure of the categories, news, information and rumor 7

2.1.2 Rumors versus gossip 10

2.1.3 Summary of rumor characteristics 10

2.2 Historical background to studies on rumors 10

3 Rumors and the Theory of Finance 15

3.1 Rumors and Behavioral Finance 15

3.1.1 Theoretical excursion: A formal definition of the value of

information 15

3.1.2 The relationship between the value of information and efficient

markets 16

3.1.3 The criticisms of Behavioral Finance 17

3.1.4 The link between rumors and Behavioral Finance 18

3.1.5 Financial markets as a fruitful ground for rumors 19

3.1.6 Six types of rumors 20

3.1.7 Classification of rumors in financial markets 21

3.2 Rumors and rational behavior 21

3.2.1 Rationality in the classical Theory of Finance 22

3.2.2 Bounded rationality 24

3.2.3 Procedural rationality 25

3.2.4 An action is always rational 26

3.2.5 Rationality in financial markets 27

3.3 Empirical studies of rumors in the stock market 29

3.4 Review of models on rumors 31

3.5 Ethnographical studies 34

4 Legal Aspects of Rumors in Financial Markets 37

4.1 Rumors in financial markets and insider trading 37

4.1.1 Introduction 37

4.1.2 Review of scientific literature on insider trading 40

4.2 Review of models on insider trading 43

4.2.1 Models of insider trading regulation 43

4.2.2 Models of trading by registered insiders 44

4.3 Rumors in financial markets and price manipulation 45

4.4 Review of models on market manipulation 48

5 Survey of Rumors in Financial Markets 51

5.1 The survey and its intention 51

5.2 Participant profile 51

5.2.1 Survey parameters 51

5.2.2 Survey participants 52

5.3 Development of rumors 53

5.3.1 How rumors start and why 53

5.3.2 Correlation between market volatility and frequency of rumors 56

5.3.3 What is the source? 57

5.3.4 First actions on a rumor 58

5.3.5 Action on specific versus general rumors 59

5.4 Spreading of rumors 59

5.4.1 To spread or not to spread? 59

5.4.2 First or last in the row? 60

5.4.3 Spreading time: How long it takes 61

5.5 Belief in rumors 63

5.5.1 Why rumors are believed 63

5.5.2 Does it matter what you believe? 65

5.6 Network formation 66

5.7 Trading on rumors 69

5.7.1 Systematic price patterns? 69

5.7.2 Rumor sources and profits 69

5.7.3 Thoughts triggered by the price movement 70

5.7.4 Actions triggered by the price movement 72

5.8 Rumors versus information 73

5.8.1 Trading on rumors versus trading on information 73

5.8.2 The difference between a rumor and information 74

5.9 Conclusions from the survey 75

5.9.1 Rumors follow logical rules 75

5.9.2 Prices reflect beliefs 76

5.9.3 Investment strategies on rumors 77

5.9.4 Relating the results to other studies 78

6 Rumor Experiments 79

6.1 Why use experiments as a research methodology? 79

6.2 Methodological pre-considerations 81

6.2.1 Internal versus external validity 81

6.2.2 Selection of participants 82

6.2.3 Payment of participants 82

6.3 Review of previous rumor experiments 82

6.3.1 The psychological experiments of DiFonzo and Bordia 82

6.3.2 An economic approach towards rumor experiments and their

structuring in this book 84

6.4 First stage experiments: Ambiguity aversion in a financial market 85

6.4.1 A brief overview of ambiguity aversion 86

6.4.2 Experimental design 96

6.4.3 Results of the first stage experiments 98

6.4.4 Discussion 101

6.4.5 Conclusion 105

6.5 Second stage experiments: Varying rumor messages 106

6.5.1 A brief discussion of the existing literature 106

6.5.2 Experimental design 108

6.5.3 Results of the second stage experiments 109

6.5.4 Conclusion 113

6.6 Third stage experiments: Testing herd behavior 113

6.6.1 A brief overview of herd behavior in financial markets 114

6.6.2 Experimental design 121

6.6.3 Results of the third stage experiments 122

6.6.4 Discussion and conclusion 127

6.7 Fourth stage experiments: Communication 128

6.7.1 A brief overview 128

6.7.2 Experimental design 129

6.7.3 Results of the fourth stage experiments 130

6.7.4 Discussion and conclusion 137