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Introduction:
The
essential
question,
which
is
to
be
answered,
is:
Do
the
asset
markets
offer
rational
signals
as
to
where
to
invest
real
resources?
The
presented
article
and
the
related
article
all
take
different
aspects
to
whether
or
not
the
efficient
market
theorem
is
achievable.
Essential
to
the
efficient
market
theorem
is
the
idea
of
the
law
of
one
price.
The
law
of
one
price
stipulates
that
it
must
not
be
conceivable
that
an
asset
is
sold
at
two
different
prices
simultaneously.
This
law
is
essentially
driven
by
arbitrage.
Given
that
arbitrage
is
the
exploitation
of
such
discrepancies
on
the
market
it
would
automatically
eliminate
any
violations
of
this
law.
Hence
arbitrage
works
as
a
key
driver
to
enforcing
the
law
of
one
price.
In
regards
to
the
market
and
the
perception
of
efficiency
there
are
some
fundamental
aspects,
which
complicate
the
existence
of
the
law
of
one
price.
Essentially
they
relate
to
the
fact
that
it
is
extremely
difficult
to
identify
and
determine
the
fundamental
value
of
the
problem-
this
is
also
referred
to
as
the
problem
of
the
joint
hypothesis.
Furthermore,
one
will
find
that
identifying
and
evaluating
fundamental
risk
is
also
extremely
difficult.
An
additional
aspect,
which
exists
in
the
intermediate
run,
is
the
noise-
trade
risk,
stemming
from
the
fact
that
investor
sentiments
may
shift,
given
that
an
investor
may
fund
and
short
fundamentally
mispriced
assets,
enforcing
the
mispricing.
Even
in
the
event
that
these
risks
will
be
eliminated
in
the
long
run,
the
trader
faces
transaction
costs,
which
in
terms
creates
difficulty
in
the
enforcement
of
the
law
of one price. In the face of transaction costs the arbitrageurs are forced to price an asset at a different price than its fundamental value. The paper investigated looks at the definite violation of the law of one price, which is the situation of carve-outs followed by a spin-off. Notice that to be certain that it necessarily is a violation of the law, the carve-out must be negative. Carve-outs are defined as an IPO for shares in a subsidiary company. The subsidiary company raises money by selling shares to the public and then typically giving some or all the proceeds to its parent. While a spin-off is defined as when the parent firm gives remaining shares in the subsidiary to the parents shareholders this means that no money fundamentally changes hands between the firms. To understand these actions it is central to understand what the reasons are to impose this situation. The reasons relate to the fact that the parents wish to raise capital for themselves or for their subsidiary to use. Additionally, the firm may want to disperse its shareholders such that it gains a form of corporate control and furthermore it will manage to diversify its risks. Moreover, carve-outs may serve as a mean to avoid flooding of the market; therefore they wish to sell in small pieces initially. Finally, it may in fact serve as a mean for adjusting the price. Particularly it may serve as a mean of raising the price of the parent if they are underpriced while the subsidiary may be overpriced. The remainder of the text will focus on the sample and the analysis conducted by Lamont and Thaler. From then on, we will on describing why and how the stocks become negative stubs. This will lead us to our discussion of the paper Is this in
fact a effective way of portraying the violation of the law of one price as well as the discussion regarding sample size and sample evaluation.
Summary:
Following
the
introduction,
section
2
of
the
research
paper
focuses
on
the
sample
of
carve-outs
followed
by
spin-offs,
which
have
resulted
in
negative
stubs.
Generally,
a
carve-out
is
an
IPO
for
shares
in
a
subsidiary
company
to
raise
money
by
selling
shares
to
the
public
and
then
typically
giving
some
or
all
proceeds
to
its
parent.
This
action,
as
was
discovered
by
many
psychologists
like
Allen
and
McConnell
and
others,
helps
the
parent
company
raise
capital
for
itself.
The
parent
company
might
want
to
establish
a
dispersed
base
of
shareholders
in
the
subsidiary
for
strategic
reasons
or,
for
example,
raising
the
parent
stock
is
particularly
attractive
if
the
parent
stock
is
underpriced
or
if
the
subsidiary
is
overpriced.
During
this
process
a
spinoff
occurs
when
the
parent
rm
gives
the
remaining
shares
in
the
subsidiary
to
the
parents
shareholders.
Next,
in
our
case,
one
could
define
stub
as
a
stock
representing
the
remaining
equity
in
a
corporation
left
over
after
a
spin-off.
Out
of
155
cases
of
carve-outs
from
1985
till
2000,
only
18
tech
stocks
were
considered
from
1996
till
2000,
as
they
had
sufficient
information
to
be
investigated.
The
study
concentrates
more
on
six
cases
out
of
the
18,
as
these
cases
showed
negative
stubs,
meaning,
subtracting
the
product
of
the
spin-off
distribution
ratio
and
the
subsidiary
price
from
the
price
of
the
parent
would
result
in
a
negative
value.
Hence,
a
clear
violation
of
the
law
of
one
price.
The
next
section
deals
with
the
risk
and
return
on
stubs.
Since
negative
stubs
are
a clear evidence of mispricing, the ideal strategy would be to buy the parent (as it is undervalued) and to short the subsidiary (as it is overvalued). This would be an easy, low-risk high-return investment, opportunity for arbitragers thus sending the stock prices to their fundamental values and eliminating the mispricing. However, according to the authors paper work and calculations, this type of investment is not likely to happen and is in fact less conveyable than portrayed. Before continuing with the constraints of such investment strategy, the authors first point out some risks that are specific to stubs. The first is cancelling the spin-off, which could happen for legal or managerial reasons and has actually been recorded in one of the positive stubs cases. The other risk is changing the distribution ratio, which could result in several complications. After explaining the process of shorting, section 4 elaborates why the strategy of buying parent and shorting subsidiary does not work. The main reasons for the failure of this strategy are the market and firm-specific risks, and the short- sale constraints. In general, fundamental, noise-trader, liquidity and idiosyncratic (firm-specific) risks, and the huge costs and difficulties of shorting, limit the arbitragers from implementing the strategy and force the existence of mispricing. Later on, the authors confirm the constraints of the shorting by checking and analyzing the options prices of the negative stubs, which by their turn also showed clear evidence of mispricing. Finally, the authors talk about two important factors that cause mispricing in the first place. The first factor is the investor characteristics. In our case, investors were too optimistic and overconfident, and did not show rational behavior. Another general characteristic would be that according to different beliefs,
investors come with acts that they would justify as rational. The second factor is the IPO day returns. Records have shown that parent companies gain excess returns of about to 2 percent on the announcement of carve-outs. This could be the result of optimistic investors drive up the price of the parent on the announcement days and later get rid of the parent in order to obtain the subsidiary on the IPO day.
Evaluation:
As
we
have
seen
after
the
introduction,
the
research
paper
continues
with
introducing
the
sample
that
was
investigated,
then
the
risk
and
return
on
stubs,
later
the
short-sale
constraints
and
finally
what
causes
the
mispricing,
before
ending
with
the
conclusion.
Structural-wise,
in
section
4,
where
the
authors
talk
about
the
short-sale
constraints,
they
start
by
describing
the
shorting
process.
We
think
that
this
should
have
been
illustrated
a
bit
earlier,
especially
that
shorting
was
mentioned
in
section
3
on
the
risk
and
return
on
stubs.
Talking
about
the
sample,
the
authors
searched
for
carve-outs
from
year
1985
till
2000
and
have
found
155
cases
but
were
only
able
to
consider
18
cases
due
to
the
lack
of
information
about
the
others.
These
18
cases
were
from
the
period
of
1996
to
2000
and
only
6
had
clear
negative
stubs.
It
is
clear
that
sample
was
very
small
and
also
just
33%
of
the
18
cases
showed
negative
stubs.
The
persistence
of
the
mispricing
could
have
existed
for
other
reasons
than
just
the
constraints
of
the
short-sale.
A
larger
sample
would
have
definitely
given
a
clearer
view.
One
should
not
also
forget
that
the
period
of
these
18
cases
was
during the dot-com bubble, where the Tech stocks prices were rising much higher than their fundamental value, hence another form of mispricing to be added to the parent and subsidiary stocks. In other words, we could say that this investigation of mispricing in carve-outs was done on Tech stocks that were, in the first place, mispriced. In section 3, Risk and Return on Stubs, the authors state in the first paragraph that the ideal strategy to profit from negative stubs is to buy the parent and short the subsidiary. However, they add that on paper such strategy will not work although they are aware of individual investors who did make money on these situations. One could comment by saying that the reason Behavioral Finance came to life is that investors and markets behave opposite to what theories on papers stated. So, we believe that it would have been more beneficent to investigate how some investors made money out of it and not why the majority did not make money out of it. In addition, this would contribute to reducing mispricing. Moreover, since the headline of the paper states Mispricing in Tech Stock Carve- outs, the majority of the paper was trying to show evidence that the researched cases were clear negative stubs and that arbitrage was not able correct the mispricing, but it did not focus much on the reasons of the mispricing. We believe that giving the causes of mispricing more attention could lead to the reduction of mispricing and thus a more rational market. In general, the risks, short-sale constraints and the reasons of mispricing did not include all six cases. For example: the risks on stubs were just hypothetical and were not present in any of the six cases and the strong evidence of short-sale
constraints in options was found in only two cases out of the three that had options traded. This brings us to the point that investigating a larger sample could have resulted in better conclusions.
Conclusion:
In
conclusion
there
are
clearly
some
cases
of
mispricing,
as
the
3Com
Palm.
This
evidence
becomes
even
more
strong
and
unquestioned
when
you
evaluate
the
use
that
the
author
made
of
the
instruments
(negative
stubs)
to
measure
this
issue,
being
cautious
to
consider
as
undoubted
mispricing
just
the
ones
that
had
relevant
negative
stubs
for
a
relative
long
period
of
time.
Even
being
so
strict,
trying
to
avoid
skeptical
people
arguments,
six
cases
were
identified.
After
identifying
six
clear
cases
that
violates
the
law
of
one
price,
one
could
ask
why
this
mispricing
was
not
quickly
corrected.
The
explanation
found
by
the
author
is
that
this
correction
took
some
time
to
happen
because
it
didnt
present
arbitrage
opportunities,
mainly
because
of
the
transaction
costs
involved
in
shorting
the
subsidiary
companies.
Even
finding
clear
cases
of
violation
of
the
law
of
one
price,
the
author
sustain
a
skeptical
opinion
about
the
existence
of
recurring
violation,
as
the
finding
of
six
cases
is
almost
insignificant
comparing
to
the
size
of
U.S.
equity
market,
and
all
of
them
were
examples
of
just
one
group,
Internet
Stocks.
In
this
point
the
author
seems
to
be
really
realistic
with
his
findings,
not
trying
to
see
the
evidence
as
something
unquestionable
and
generalized,
also
the
paper
leaves
the
validation
of
the
law
of
one
price
weaker
but
still
as
a
question:
is
the
market
efficient
enough
to
guarantee
that
generally
all
prices
are
right?