A lot of ink is spilled about the “information markets” but a lot of writers ignore just how much of the pricing of markets is due to information-free arbitrage and represents how markets work (and not information). For example the over 2% price decline in IBM actually tells us almost nothing- it is to be expected.

The quantity to look at is not price, but the total market value of IBM plus Sun.

If the market is in equilibrium Sun’s price should increase by an amount equal to the premium IBM is thought to be willing to pay for the stock times the perceived probability of the deal going through. Sun right now is $8.72 (up from $4.97) so it is safe to assume IBM is offering nearly a 100% premium on Sun stock and the market is fairly certain the deal will go through. So Sun’s total market cap (price per share times total number of shares) rose from $3.7 billion to $6.5 billion (or a net increase of $2.8 billion).

IBM’s price slid from $92.91 to $90.83 this means that its market cap fell from $124.7 billion to $121.9 billion or a loss of around $2.8 billion. Almost identical to the increase that priced Sun up 75%.

So the market is pricing IBM + Sun today very very closely to what the sum of prices yesterday. I would interpret this as yielding no information other than the fact that the market feels IBM will pay a substantial premium for Sun (and that the deal is likely to go through, yielding the 75% single day price in increase in Sun). The fact that the sum of market caps is so well preserved indicates that no big player has yet started trading on a strong opinion if the deal is good or bad.

All of the above arguments are “arbitrage-like.” The idea is if the market mis-priced the sum of IBM plus Sun then an informed trader could profit by taking an informed contrary position (it is not true arbitrage because the trader would have to take a risky position for a period of time) and waiting until some time after the merger finishes (or fails) to take a profit. Of course, as is now painfully obvious, all such arguments are irrelevant if the market locks up. Without a fluid market there is no reason for complicated combinations of investments to price lock step with each other.

Related posts:

1. Is Search Advertising a Market for Lemons?
2. A Discrete Model Gauging Market Efficiency
3. It is not all the quants’ fault.

In “stag hunt” a number of hunters set out cooperate and hunt (with a guaranteed result) a single stag together (and split the benefits). The twist in the game is that to succeed the hunters all must cooperate and if a single hunter fails to show up they will not catch the stag. The problem is that each hunter can individually hunt a hare and with certainty come away with a hare (even though the value of the hare is much less than the expected value of the hunter’s portion of the stag). This is a sad game in that it is indisputably the case that for each player the best outcome is when they all hunt the stag together, but most players will likely “defect” and hunt hares. This game is similar to the “prisoner’s dilemma” but worse in that players in stag hunt defect solely out of fear and not for additional selfish benefit (as found in the prisoner’s dilemma).

How does this relate to the Yahoo/Google deal? Google got a minimum commitment from Yahoo to serve $83 million worth of Google ads on the Yahoo portal. Google is one of the few entities for which $83 million is a pittance. However it is enough traffic to generate statistics that will make it obvious to each and every Yahoo executive that the Google ads are worth around 30% more than Yahoo self-served ads (the typical historic difference in the quality of matching of the two services). So every quarter each and every Yahoo division head can decide whether to “hunt stag” (route advertising into the Yahoo system and help collect the data and experience to eventually eliminate any Google premium) or “hunt hare” and route more of their division’s business to Google for a higher immediate revenue.

Without this deal (and the intense scrutiny Yahoo is under) Yahoo would literally have all the time in the world to fix their advertising system. They are a very large company and their current system, though inferior, is profitable. So Yahoo can finance self-improvements indefinitely. It is unfortunate that Yahoo’s last few attempts at improvement (“Panama”) were not enough- but there was no reason this should have been the last attempt.

With this deal Yahoo rapidly routes all of its revenue through Google’s system. Actually because “division performance” is a positional good it could happen very rapidly (even if a division executive has the moral strength to not take the Google profits, he or she will be out-competed by a sister division executive that does and gets promoted past them). Yahoo is rapidly reduced to a farmer selling land and machinery to (temporarily) feed their family.

Once all of Yahoo’s revenues are routed though Google Yahoo will be completely blind to how their revenue is derived (unable to even confirm they are getting their promised cut: see Comparing Apples and Oranges). Furthermore Yahoo will move from being a trove of valuable content to fulfilling Google’s definition of being a “link farm” (Google has never posted the definition of this undesirable designation- but empirically you seem to match it if you serve Google ads).

Finally, Yahoo will be completely at Google’s mercy.

To quote Vinton Cerf VP and Chief Internet Evangelist at Google:

“In the case of Yahoo, the company believes that it will be beneficial to assist Yahoo with its experiment.”

Related posts:

1. Should your mom use Google search?
2. Public Service Article: JSTOR and other Useful Research Archives
3. What does the Market Think?