COMPANIES &MARKETS - Inseader trading, cheap talk and big tickets - GLOBAL INVESTOR.
763 words
7 February 2000
Financial Times
(c) 2000 The Financial Times Limited. All rights reserved

This is the cautionary tale of the ball and the bubble: how "cheap talk" scared speculators and drove down prices, but still left a student with cash in hand.

The bubble is any extreme overvaluation of asset prices. The ball is the dance organised twice a year by students of Insead, the prestigious business school near Paris - specifically the summer ball which took place in May 1994.

Raghavendra Rau, assistant professor of finance at Purdue University, Indiana, draws the two together in an intriguing new paper in which he develops a model to show that "cheap talk" - inconsequential information, which should have no bearing on market prices - can cause bubbles to burst.

This is timely. Chat-rooms on the web are the new drug for many amateur investors, and loose talk on the internet already affects shareholder behaviour. Companies are devoting time and money to seeking out damaging rumours on the internet and scotching them - or spreading a few useful rumours of their own.

Just occasionally, something new and true crops up: for instance, super-vigilant cybersleuths could have spotted chat-room hints in advance of the recent Time Warner-EMI deal, the America Online-Time Warner mega-merger, and the announcement of talks (since aborted) between Procter &Gamble and Warner Lambert. But most of what is posted is gossip rather than news.

Such cheap talk should have little impact on prices. Most crashes are triggered by new information, however trivial, relevant to pricing of the assets. Not, however, in the case of the Insead ball.

The sale of tickets had always attracted healthy speculation, via an e-mail system used by Insead students and faculty. Tickets were limited, demand was often fuelled by alumni returning for an annual reunion, and many of the business school's students were hungry both for cash and for an opportunity to put into practice a few of the trading strategies with which they were familiar.

But at the beginning of May 1994, with prices in the secondary market at FFr1,100 a ticket (already about two thirds higher than the official price), a student put out an e-mail castigating his peers for trying to make a fast buck.

He offered to set an example by selling his tickets at face value and, a day later, claimed he had done just that. The student never revealed whether he had held the tickets at all, let alone sold them at the knock-down price.

But the bubble in the aftermarket burst almost immediately. Prices fell 30 per cent and never recovered, in spite of speculators' brazen attempts to prop up trading by reminding fellow students that alumni would be prepared to buy at almost any price in the days leading up to the dance.

Given that the arrival of an "ethical" seller did not add any new information to the market about likely demand for the tickets, Prof Rau supposes that the rogue e-mails disrupted the common knowledge that everybody was in the market to maximise his or her profit.

That destabilised trading, and those students who were most worried about low demand for tickets then preferred to sell at a lower price rather than risk being unable to do so later.

Prof Rau's model - the premise for which I have certainly oversimplified - also factors in the unreliability of electronic communication, which he believes adds to the risk of inconsequential information disrupting the market.

As for the possibility that the ethical seller had successfully convinced the other students to abandon the profit motive, Prof Rau dismisses that out of hand. "These are MBA students," he says. "It's difficult to believe that everybody suddenly became ethical."

Whether or not you believe that US high-technology stocks are overvalued, the volume of virtual investment chat is increasing, and with that the risk, if Prof Rau is right, that cheap talk rather than concrete information will induce the next correction. The technology-weighted Nasdaq Composite index hit another new high on Friday, incidentally.

There was, however, a happy ending to the tale of the ball and the bubble for one student. Prof Rau himself managed to sell his ball tickets at an inflated price. The buyer was an over-hasty Insead alumnus who was not aware that the market had crashed - a case (incautious investors, please note) of lack of common sense, rather than lack of common knowledge.

Copyright Financial Times Limited 2000. All Rights Reserved.

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