Law of one price Flashcards
Write the definition of the law of one price
LOOP- identical goods must have identical prices. In capital markets- identical securities must have identical prices, otherwise, smart investors are able to recognize arbitrage opportunities and make unlimited profits buy buying the cheap one and selling expensive one. Over the last decade, numerous violations have been detected.
Assumptions for LoOP
- Competitive market;
- No transaction costs;
- No barriers to trade.
Violations of LoOP
Closed-End Country Funds American Depositary Receipts Twin Shares Dual Share Classes Corporate Spinoffs
Closed-End Country Funds
This is a form of mutual fund. Closed-end Country funds are mispriced; however, there are explanations for that. Underlying securities of the fund and the fund itself are not exactly identical. Portfolio manager charges the fee for his services and incurs other services. This explains discounts. Even premia would be rational, if a manager had superior stock picking ability. Nevertheless premia and discount can little justify returns. There were some examples of country funds that traded foreign stock on US market, and those funds had a great premium. The question is still unanswered, why investors were willing to pay such a big premium. One possible answer is that there are trade barriers.
American Depositary Receipts
These are shares of specific foreign securities held by U.S. financial institutions. They are created to make it easier for U.S investors to own shares in foreign companies. These funds have prices that are different from the value of underlying assets, although in most of the cases the deviations are not so large. The same asset can have different prices in different markets, reflecting differences in supply and demand. For example, we might value foreign stock more, as they offer valuable diversification.
Twin Shares
Some firms have for historical reasons two types of shares with fixed claims on the cash flows and assets of the firm (for example, Royal Dutch/ Shell Group). One type of assets can be traded at a premium. Arbitrageurs do not use this opportunity of selling short overpriced stock, because there is a risk that mispricing can even widen. Why investors don’t buy whatever stock is cheaper? Because they track the S&P500 index, and more expensive version is included there.
Dual Share Classes
Sometimes companies have two different types of shares with different voting rights. They are trade at about the same price, except at times, when there is some battle for corporate control, in which case the voting stock is more valuable.
• different voting rights → premium for control
Corporate Spinoffs
When company has a subsidiary and offers the shares of the subsidiary on IPO, the price of subsidiary’s shares increase dramatically, while the price of parents’ shares drop. People preferred to buy expensive shares of subsidiary instead of cheap parent’s share, in which the subsidiaries are already embedded. Explanation: only small portion was sold, so the demand outstripped supply. Arbitrageurs were unable to sell short, because the supply was so small that they could not borrow.
Example of Palm and 3com
1) 3Com decided to spin off its Palm division, presumably to “unleash” its true value.
2) The first step was an “equity carve-out,” in which 3Com sold a small portion (5%) of the value of Palm in an initial public offering (IPO).
3) The second step, called the “spinoff,” would take place in about six months. At this point, the remaining 95 percent of the shares would be distributed to 3Com shareholders
4) When the spinoff took place, each 3Com shareholder would receive 1.5 shares of Palm
5) Investors were willing to pay over $2.5 billion dollars (based on the number of Palm shares issued) to buy expensive shares of Palm rather than buy the cheap Palm shares embedded in 3Com and get 3Com thrown in.
Conclusion of the article
The Law of One price says that if the same asset is selling for two different prices simultaneously then arbitrageurs will step in, correct the situation and profit at the same time. However, there are constraints and limits on the market: short-sale constraint, risks of widening of the spread, no good substitutes that make the law of one price “violated”.
