“Anomalies: The Law of One Price in Financial Markets” Lamont, Owen A. and Richard H. Thaler Flashcards
What is the main idea?
Looking into cases when the Law on One Price (probably) doesn’t hold
What does the Law of one price state?
If there are no transaction costs, barriers to trade or other constraints, e.g., short selling, then identical goods must have identical prices.
In capital markets, the Law says that identical securities must have identical prices, otherwise smart investors could make unlimited profits by buying cheap and selling expensive
What are the two essential ingredients to violation of the LOP?
◦ Some agents have to believe falsely that there are real differences between two identical goods
◦ There have to be some constraints to prevent rational arbitrageurs from restoring the equality of prices that rationality predicts
What are Closed-End Country Funds?
Closed-End Funds (CEF) – Special sort of mutual funds, they issue shares in the fund that trade in markets, capital doesn’t flow in/out after their IPO
Closed-End Country funds are traded domestically, but can hold foreign equity (larger deviations between price and value than all-domestic funds)
o CEF prices and net asset values can vary across funds and across times with both discounts and premia
The discounts and premiums can be a violation of the Law, but the two assets (securities owned by the fund and the fund itself) aren’t precisely identical
What causes the mispricing of Closed-End Country Funds?
o Legal barriers: Taiwan country fund was launched in US, it traded at a big premium
o Short-sale constraints
What are American Depositary Receipts?
ADRs are shares of specific foreign securities held in trust by US financial institutions.
Price discrepancies don’t happen often, because of arbitrage opportunities
What causes mispricing of ADRs?
Legal barriers stopped Americans from buying the stock directly from India (could buy ADRs tho), but it was valuable for diversification, so ADRs sold at a big premium (Infosys in India and ADRs)
What are Twin Shares?
Siamese Twins – Firms that for historical reasons have 2 types of shares with fixed claims on the CFs and assets of the firm (2 firms merged together)
What causes mispricing of Twin Shares?
Example: Royal Dutch/Shell Group (the stocks of both fluctuated around a lot, but theoretically should have a ratio of 1.5, because they had split CFs 60/40)
Reasons for mispricing:
o One should buy the cheap one and short the expensive one to make a profit in the very long run, but it may not work in short run, which is why there is mispricing
o Royal Dutch was a member of S&P 500 index, index funds tracking S&P 500 were forced to buy the more expensive version of the stock
What causes mispricing of Dual Class Shares?
Usually, these 2 classes trade at about the same price
Reasons for mispricing:
o Battle for corporate control
o Molex shares with voting rights were put on S&P 500 – index funds tracking S&P 500 were forced to buy the one with voting rights, it became more expensive
What are Corporate Spinoffs?
When a company turns a part of the company into a separate company.
In the case of a corporate spinoff, it can happen that the relationship between the price of 2 stocks is bounded by some common ratio
What causes mispricing during a Corporate Spinoff?
Barriers.
- 3Com (American IT company) was planning to spin-off its Palm division
- 3Com gave 5% of their equity to the Palm company, and in 6 months 1.5 of Palm’s shares were supposed to be issued per 1 3Com share
- During IPO, Palm shares skyrocketed, 3Com fell – why would anyone buy those expensive Palm stocks?
- Arbitrage opportunity: Buy 1 3Com share, short 1.5 Palm shares and wait 6 months
BARRIER: most shares were owned by retail investors and it is difficult to borrow a share from them to short sell (usually institutional investors lend)
Do violations of the Law create arbitrage opportunities?
Violations of the Law don’t generally create arbitrage opportunities (sure profits with no risk), they just create good but risky bets.
The risks to arbitrageurs are particularly large when there is no specified terminal date
In the short run, mispricing can get worse before it gets better, even causing financial distress to arbitrageurs
Did the cases prove a violation of the Law?
No, none of them were a clear violation of the Law. All of them had potential explanations for mispricing and no riskless arbitrage opportunities that would drive the price back to normal.
These cases, however, made authors feel like that markets are not perfect.
