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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