Limited Arbitrage in Equity Markets

Limited Arbitrage in Equity Markets,10.1111/1540-6261.00434,Journal of Finance,Mark Mitchell,Todd Pulvino,Erik Stafford

Limited Arbitrage in Equity Markets   (Citations: 94)
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We examine 82 situations where the market value of a company is less than its subsidiary. These situations imply arbitrage opportunities, providing an ideal set- ting to study the risks and market frictions that prevent arbitrageurs from imme- diately forcing prices to fundamental values. For 30 percent of the sample, the link between the parent and its subsidiary is severed before the relative value discrep- ancy is corrected. Furthermore, returns to a specialized arbitrageur would be 50 per- cent larger if the path to convergence was smooth rather than as observed. Uncertainty about the distribution of returns and characteristics of the risks lim- its arbitrage. 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 com- pany is less than that of its ownership stake in a publicly traded subsidiary. These situations suggest clear arbitrage opportunities, yet, they often persist, and therefore provide an interesting setting in which to study the risks and market frictions that prevent arbitrageurs from quickly forcing prices to fundamental values. Arbitrage is one of the central tenets of financial economics, enforcing the law of one price and keeping markets efficient. In its purest form, arbitrage requires no capital and is risk free ~see Dybvig and Ross ~1992!!. By simul- taneously selling and purchasing identical securities at favorably different prices, the arbitrageur captures an immediate payoff with no up-front cap- ital. Of course, pure arbitrage exists only in perfect capital markets. In the real world, imperfect information and market frictions make what is re- ferred to as "arbitrage" both capital intensive and risky. Imperfect information and market frictions can impede arbitrage in two different ways. First, when there is uncertainty over the economic nature of an apparent mispricing and it is at least somewhat costly to learn about it, arbitrageurs may be reluctant to incur the potentially large fixed costs of entering the business of exploiting the arbitrage opportunity ~Merton ~1987!!. * Mitchell and Stafford are at Harvard University, and Pulvino is at Northwestern Univer- sity. We thank Brad Cornell, Kent Daniel, Mihir Desai, Rick Green, Ravi Jagannathan, Owen Lamont, André Perold, Mitch Petersen, Julio Rotemberg, Rick Ruback, Tuomo Vuolteenaho, an anonymous referee, and seminar participants at the Federal Reserve Bank of New York, Har- vard Business School, Ohio State University, U.S. Securities and Exchange Commission, and the 2001 Spring NBER Asset Pricing Program Meetings for helpful comments. We also thank Asma Qureshi for research assistance, Ameritrade Holding Corporation for short-rebate data, and especially Ken French for insightful comments and discussions. Harvard Business School's Division of Research provided research support.
Journal: Journal of Finance - J FINAN , vol. 57, no. 2, pp. 551-584, 2002
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