Guiding Seminar 1B (2020) Flashcards
“Anomalies: The Law of One Price in Financial
Markets” - (Lamont, O. A., Thaler, R. H. (2003))
What is the Law of One Price?
If there are no transaction costs or other constraints, identical goods must have identical prices.
“Anomalies: The Law of One Price in Financial
Markets” - (Lamont, O. A., Thaler, R. H. (2003))
What usually happens in financial markets if Law of One Price does not hold?
If the Law of One Price does not hold and two identical securities are traded at different prices, an arbitrageur will exploit an arbitrage opportunity - making riskless profit by trading the mispriced assets).
“Anomalies: The Law of One Price in Financial
Markets” - (Lamont, O. A., Thaler, R. H. (2003))
What are the types of financial assets that violate the law of one price?
- Closed-End Country Funds
- American Depositary Receipts
- Twin Shares
- Dual Class Shares
- Corporate Spinoffs
“Anomalies: The Law of One Price in Financial
Markets” - (Lamont, O. A., Thaler, R. H. (2003))
How do Closed-End Country Funds violate the law of one price?
Introduction for dummies:
Similarly to an ETF, a Closed-End Fund trades like simple company stock. However, a closed-end fund is different from an open-end fund in a way that after its shares are publicly offered to potential investors, the fund’s manager issues NO additional shares. If you want to get a Closed Fund share, you can only buy it from other people who want to sell their share of the particular Closed-Fund.
How does a closed-end fund violate the law of one price?
While an open-end fund’s share price is based on its net asset value (NAV), a closed-end fund’s share price works just like a usual stock price which fluctuates according to its supply and demand. So, although a closed-fund share price should also be based on its NAV, the changes in investor demand can lead to a closed-end fund trading at a premium or a discount to its NAV. Even though moderate discounts/premia can be justified by management fees, expenses, superior stock-picking skills, the share price of average should equal its NAV (Law of One Price).
What happened in real life?
Taiwan country fund (shortly after its launch in the U.S. in 1987, it traded at a 205% premium - nothing can sufficiently explain the mispricing - why pay $1 for $0.33 of assets?)
German country fund - had traded at 100% premium after the Berlin Wall fell
“Anomalies: The Law of One Price in Financial
Markets” - (Lamont, O. A., Thaler, R. H. (2003))
How do American Depository Receipts violate the law of one price?
Introduction for dummies:
American Depositary Receipts are a convenient and popular way for investors to buy stocks of companies based outside the U.S. ADRs exist because many foreign companies do not want to bother with the expense and hassle of directly listing their shares on U.S. stock exchanges.
How it works:
- A broker will buy shares of foreign companies trading on their home exchanges.
- The broker will deliver these shares to a holding bank where the shares will stay.
- Another type of bank - a depositary bank - will issue shares called “Receipts” (aka ADRs) on basis of those shares held by the holding bank. Those receipts can then be traded on a U.S. exchange just like any other share. The share price, as well as dividends are collected in US dollars.
What happened:
An ADR of an Indian company “Infosys” was trading at a 136% premium relative to Infosys’ Bombay-listed shares, violating the law of one price. However, the LOOP was not violated THAT much as article says that investors who saw this could not use the arbitrage opportunity to the fullest because US investors could not trade Indian shares. Moreover, the ADR premium was extremely volatile and most likely could not hold on for long.
“Anomalies: The Law of One Price in Financial
Markets” - (Lamont, O. A., Thaler, R. H. (2003))
How do Twin Shares violate the law of one price?
Introduction for dummies:
An example provided in the article is about Royal Dutch/Shell twin shares. Royal Dutch & Shell are a dual-listed company - it is a corporate structure in which two corporations function as a single operating business, but retain separate legal identities and stock exchange listings. The shares of dual-listed companies represent exactly the same underlying cash flows - therefore, at efficient financial markets, stock prices of the companies should move similarly. But, in real life, they don’t - and investors are trying to exploit the mispricing by setting up arbitrage positions in such circumstances. These arbitrage strategies involve a long position in the relatively underpriced part of the dual-listed company and a short position in the relatively overpriced part.
What happened:
Royal Dutch shares (traded in Amsterdam, S&P500 member) receive 60% of the company’s profits, while Shell shares (traded in London) get the remaining 40%; BUT the ratio of the share prices was significantly deviating from 1.5 (40*1.5=60 or that’s how much “higher” the Royal Dutch shares were allowed to be according to Law of One Price).
An explanation on why these Twin Shares supposedly did not fit LOOP:
Different index membership can result in twin shares being mispriced. When Royal Dutch was excluded from the S&P 500 index, the premium quickly fell to 0, restoring the hypothetical 1.5. ratio of share prices
“Anomalies: The Law of One Price in Financial
Markets” - (Lamont, O. A., Thaler, R. H. (2003))
How do Dual Class Shares violate the law of one price?
What are dual-class shares? Two classes of shares for the same company, but with different voting rights (e.g. Class A gets 1 voting right per share, Class B gets 10). The two are supposed to trade at about the same price unless when there is some battle for corporate control.
What happened?
For a company “Molex”, before 1999, the premium on shares with bigger voting rights fluctuated between 0% and 10%; but, after the shares were added to the S&P 500, the premium rose to 49%. The Law of One Price does not hold and it is hard to see why voting rights would become more valuable because the firm was included in the S&P 500.
“Anomalies: The Law of One Price in Financial
Markets” - (Lamont, O. A., Thaler, R. H. (2003))
How do Corporate Spinoffs violate the law of one price?
Introduction for dummies:
A corporate spinoff is a type of corporate action where a company “splits off” a specific division as a separate business
What happened?
- 3Com (parent company) was planning a spin-off of its Palm division.
- It was announced that issuance of 1.5 Palm’s shares for each share of 3Com would happen in half a year.
- In March, 2000, 5% of Palm’s shares were made public.
- By the end of the day, Palm’s market value went to 54 billion, according to shares.
- However, 3Coms market value was at 28 million.
- As only 5% of Palm were made public, theoretically, 95% of Palm still stood under 3Com, and 95%*54=around 50 million
- Therefore, 3Coms implied market value without the Palm subsidiary was 28-50=negative 22 billion, even though the company had about $10 per share in cash.
- So, an implied arbitrage opportunity appears (LOOP is violated)
- Buy cheap - a share of the extremely undervalued 3Com stock and short 1.5 of overvalued Palm’s shares.
“Anomalies: The Law of One Price in Financial
Markets” - (Lamont, O. A., Thaler, R. H. (2003))
What prevents the arbitrageurs from enforcing the Law of One Price?
Violations of the Law generally create good but risky bets, not arbitrage opportunities (certain risk-less profits).
Risks for arbitrageurs:
- Short selling constraints, such as limited lendable supply of shares (only 5% of Palm’s shares were public and of those, only the 1% was held by institutional investors who engage in block trades, which is an order to buy or sell 10,000 or more shares at a time); legal barriers that prevent access to trading in foreign markets (Infosys in Bombai) or transaction costs.
- Noise trader risk: after taking the position in such cases, the volatility of the stock usually is high, causing the net wealth of the arbitrageur to decline and can even lead possible bankruptcy before the prices/spreads converge in the desired direction (the case of Long Term Capital Management - a multi-billion hedge fund which had bets on the convergence of bond spreads (not necessary to know what is this in the context, relax) in the long term - and the spreads diverged instead of converting, and LTCM entered financial distress before proving that the bonds willl “converge in the long term”.
“Forensic Finance” (Ritter, J. R. (2008))
What are the criminal practices in the financial markets that are talked about in this article?
- Late Trading of Mutual Funds
- Employee Stock Option Backdating
- Spinnings of IPOs
- Rewriting the History of Market Recommendations
“Forensic Finance” (Ritter, J. R. (2008))
How does Late Trading of Mutual Funds violate the law?
How it should be:
- U.S.-based mutual funds calculate their Net Asset Value (which determines changes in stock market prices) once per day when stock exchanges close at 4 p.m.
- Orders received after 4 p.m. should be priced at the closing net asset value on the FOLLOWING trading day.
What happened:
In 2003, several mutual funds permitted certain hedge funds to trade after 4 p.m. at the 4 p.m. closing prices—while at the same time telling investors that such late
trading was not permitted. Many companies wait until shortly after U.S. stock exchanges close at 4 p.m. to make major announcements. These announcements frequently move the aggregate market. Trading in stocks or mutual funds after these announcements at prices that existed before the announcements can be quite profitable because it takes advantage of a stale price (a price that doesn’t fully reflect current information). In some cases, a hedge fund agreed to place money in a mutual fund that had high fees in return for being permitted to engage in late trading in other large mutual funds run by the same fund family. Lawsuit happened.
“Forensic Finance” (Ritter, J. R. (2008))
How does Backdating of Employee Options violate the law?
What happened?
Companies were choosing an option grant date after observing on what date of a month the stock had its lowest price.
When Apple share price was high ($106.56), the company announced that on January 12 ($87.19), a week earlier, it had granted options to Steve Jobs.
However, January 12 close was the lowest closing price in the previous 2 months.
Seven years later, Apple admitted that the dates of many
options grants had been chosen after the prices have already grown, and that documents showing that the board of directors had approved the grants on the dates chosen had in some cases been fabricated.
“Forensic Finance” (Ritter, J. R. (2008))
Why do companies Backdate their Employee Options?
Reasons for backdating:
1) If managers receive cheap options, they receive an increased value directly if and when the options are exercised;
2) If employees expect to receive cheap options, they should be willing to accept lower direct wages because the options will give them high returns anyways. Lowering wages lowers reported employee compensation expense and boosts
reported profits;
3) When backdated options are exercised, the realized value of the options is deductible from taxable income, lowering the company’s tax bill and conserving corporate cash.
Offsetting this last effect, however, is the fact that the company receives less cash from a lower exercise price.
“Forensic Finance” (Ritter, J. R. (2008))
How does Spinning of IPOs violate the law?
IPO Spinning is a practice of an investment bank offering under-priced shares of a company’s initial public offerings to the senior executives of a third party company in exchange for future business with the investment bank.
Because of the underpriced shares, bookrunners make
greater profits on an initial public offering if the company being sold allows greater underpricing, as an
underpriced IPO leaves money on the table.
This conflict of interest was a relatively common way for investment banks to attract new clients in the past, but has since been prohibited.
“Forensic Finance” (Ritter, J. R. (2008))
How does Rewriting the History of Market
Recommendations violate the law?
Background:
There is a trend - when all stocks are rising, recommendations will be more bullish (i.e. optimistic) on average, and the other way around, so when things go south, there’s an incentive to discreetly rewrite the overly-optimistic forecasts to protect analyst’s reputation.
What happened?
Downloads from the I/B/E/S recommendation database obtained at different points in time were not identical, although all of the downloads referred to the same sample period.
Thomson Financial claimed that the changes in analyst recommendations were caused by a programming error during acquisitions. After changes had been
introduced to the platform, the quality of data was improved for the future.
