Published in the Review of Economic Studies, the paper ‘Manipulation and the Allocational Role of Prices’ explores the relationship between a firm’s real economic value and its stock price, and how a deliberate driving down of share price in a bear raid, can lead to real economic damage to a firm.
The short sale is central to the process – that is, when a trader borrows shares from a broker, sells them, and plans to repay the loan later with shares bought for less. In this situation there is an incentive for traders artificially to drive down the value of the shares so they can buy at a lower rate.
If a rush of such short sales gathers momentum and achieves a fall in the share value, other investors may be prompted to dump their stock so initiating a downward cycle, causing real economic damage to the organisation.
Generally it has been thought that the relationship between stock price and a firm’s real economic value is not closely connected. This research shows stock movements and price can have a direct impact on its value.
‘What is interesting is that when prices find a way to affect fundamental value, a downwards movement can become a self-fulfilling prophecy,’ says Alex Guembel. ‘In the future it will be interesting to see if companies and regulators can find ways to prevent harmful manipulation without stifling the very positive role that short sales have in getting legitimate pessimistic views reflected in market prices.’
A discussion of the research in Knowledge@Wharton can be seen at http://knowledge.wharton.upenn.edu/article.cfm?articleid=1939&jsessionid=a830f0fd5e9c4e2145a6
The original article is available at http://www.restud.com/uploads/papers/MS-9510-2-submission.pdf.
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