Limited Arbitrage in Equity Markets

By Mark Mitchell, Todd Pulvino and Erik Stafford

Presented by Igor Miranda, Yiqi Li and Muhammad Shahid
Group 2
Agenda
1. Motivation for the research
2. Why arent these arbitrage opportunities always
explored?
3. Research
I. Data Description
II. Measuring Investment Returns
III. Fundamental Risk
IV. Financing Risk
V. Conclusion
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Motivation for the research
This paper examines impediments to arbitrage
in equity markets using a sample of 82 situations
between 1985 and 2000, where the market
value of a company is less than that of its
ownership stake in a publicly traded subsidiary.
These situations suggest clear arbitrage
opportunities...
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Why arent these arbitrage opportunities
always explored?
Pure arbitrage exists only in perfect capital markets. In the real
world, imperfect information and market frictions make
arbitrage both capital intensive and risky

Main Reasons
1. Uncertainty over the economic nature of an apparent mispricing
2. Path to convergence may be long and bumpy
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Research
A. Sample Selection Criteria

Two differentes methods to determine with the stub values are negative:

I. Data Description
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Research
B. Sample Construction
All Initial Public Offerings where another publicly traded firm
owned the IPO shares prior to the offering (1985-2000)
Rule 1: 70 parents/subsidiary
Rule 2: 82 parents/subsidiary

High concentration in the technology sector
I. Data Description
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Research
C. Shares Outstanding and Short Rebates

Shares Outstanding: Quarterly Financial Reports

Short Rebate Definition: Rate paid to investors on the proceeds obtained
from short selling a stock

I. Data Description
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Research
A. Investment Criteria and Thresholds


II. Measuring Investment Returns
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Research
B. Investment Capital and Financial Leverage

Theoretically, the long position would be fully financed by the proceeds
from the short position. This does not work in real markets because the
investor must post collateral for both long and short positions.

As leverage is important on both the return and the risk, the results are
presented under three leverage leves: Textbook, Regulation T and
Conservative.

1. Textbook: more aggressive, no margin calls.
2. Regulation T: 25% long / 30% short
3. Conservative: Preclude all margin calls ex post

II. Measuring Investment Returns
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Research
C. Assessing Invest Performance

To ensure that the portfolio is at least partially diversified, it
was imposed a diversification constraint which allows no
more than 20 percent of the portfolios equity to be initially
invested in any one negative-stub-value transaction.

II. Measuring Investment Returns
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Research

In this paper, fundamental refers to the possibility that the
negative-stub-value trade is terminated before prices converge
to fundamental values.

Rule 1: 66/70 terminated by December, 2000
18/66 of the deals (27.3%) the mispricing was not
eliminated
Rule 2: 77/82 terminated by December, 2000
27/77 of the deals (35.1%) the mispricing was not
eliminated



III. Fundamental Risk
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Research
III. Fundamental Risk





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Research

With 27.3% (Rule 1) and 35.1% (Rule 2) of the stub-value
investments terminating before the mispricing is eliminated, it is
clear that fundamental risk exists and that these investments are
far from risk-free arbitrage opportunities




III. Fundamental Risk
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Research
Horizon Risk
Increasing the length of the path reduces the arbitrageurs
return
Margin Risk
If the arbitrageur faces a margin call, he will be forced to post
additional collateral or partially liquidate
Ex: Creative Computers (parent) x Ubid (subsidiary)
Buy-in Risk
When owners of the stock demand that their loaned-out
shares be returned


IV. Financing Risk
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Research
IV. Financing Risk

Horizon Risk


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Research
IV. Financing Risk

Margin Risk B.1 Creative Computers / Ubid Example


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Research
IV. Financing Risk

Margin Risk B.2 Full Sample Results for Individual Investments

The Creative Computers / Ubid example suggests that ignoring margin
requirements results in overestimation of returns from negative-stub-
value investments. For that reason, we estimate returns for each NSB in
the sample using the three leverage levels.


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Research
IV. Financing Risk

Margin Risk B.3 Portfolio Results


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Research
V. Conclusion
Market forces are working hard to keep prices at
fundamental values, but the effectiveness of these
efforts is sometimes limited

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Bibliography
Mitchell, M., Pulvino, T., Stafford, E., 2002, Limited
Arbitrage in Equity Markets

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Thank You
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