By Owen A. Lamont and Richard H.

Thaler
What Does Carve-out mean?
Sometimes known as a partial spinoff, a carve out occurs when a
parent company sells a minority (usually 20% or less) stake in a
subsidiary for an initial public offering- IPO or rights offering.

What Does Scrip Mean?

A written document that acknowledges a debt.
A temporary document representing a fraction of a share resulting
from a split or spin-off.  Scrip may be applied to the purchase of full
shares.
What Does Divestiture Mean?
The partial or full disposal of an investment or asset through
sale, exchange, closure or bankruptcy. Divestiture can be done
slowly and systematically over a long period of time, or in large lots
over a short time period.
What Does Spinoff Mean?
The creation of an independent company through the sale or
distribution of new shares of an existing business/division of a
parent company. A spinoff is a type of divestiture.
Businesses wishing to 'streamline' their operations often sell
less productive, or unrelated subsidiary businesses as spinoffs.
The spun-off companies are expected to be worth more as
independent entities than as parts of a larger business.
 
What Does Split-Off Mean?
A type of corporate reorganization whereby the stock of a
subsidiary is exchanged for shares in a parent company.
 
What Does Closed-End Fund Mean?
A closed-end fund is a publicly traded investment company that raises a
fixed amount of capital through an initial public offering (IPO). The fund is
then structured, listed and traded like a stock on a stock exchange.

Also known as a "closed-end investment" or "closed-end mutual fund."

What Does Law Of One Price Mean?

The theory that the price of a given security, commodity or asset will have
the same price when exchange rates are taken into consideration. The law of
one price is another way of stating the concept of purchasing power parity.
The law of one price exists due to arbitrage opportunities. If the price of a
security, commodity or asset is different in two different markets, then an
arbitrageur will purchase the asset in the cheaper market and sell it where
prices are higher. When the purchasing power parity doesn't hold, arbitrage
profits will persist until the price converges across markets.
What Does Ex-Post Mean?
Another term for actual returns. Ex-post translated from Latin means "after
the fact". The use of historical returns has traditionally been the
most common way to predict the probability of incurring a loss on any given
day. Ex-post is the opposite of ex-ante, which means "before the event".

What Does Noise Trader Risk Mean?

A form of market risk associated with the investment decisions of noise
traders. The higher the volatility in market price for a particular security,
the greater the associated noise trader risk. Behavioral finance researchers
have attempted to isolate this risk in order to explain and capitalize upon
the sentiment of the majority of investors. Noise trader risk is assumed to
be more readily found in small-cap stocks, but has also been identified mid-
and large-caps.
For example, if the noise trader risk for a particular stock is high, an
issuance of good news related to a particular company may influence more
noise traders to buy the stock, artificially inflating its market value.
What Does Internal Revenue Service - IRS Mean?
A United States government agency that is responsible for the collection
and enforcement of taxes. The IRS was established in 1862 by President
Lincoln and operates under the authority of the United States Department
of the Treasury. It is primarily engaged in the collection of individual
income taxes and employment taxes, but also handles corporate, gift, excise
and estate taxes.
The IRS is sometimes referred to as the "tax man".

What Does Idiosyncratic Risk Mean?

Risk that affects a very small number of assets, and can be almost
eliminated with diversification. Similar to unsystematic risk.
This is news that is specific to a small number of stocks. One example is a
sudden strike by employees.
What Does European Option Mean?
An option that can only be exercised at the end of its life, at its maturity.
European options tend to sometimes trade at a discount to its comparable American
option. This is because American options allow investors more opportunities to
exercise the contract.
European options normally trade over the counter, while American options usually
trade on standardized exchanges. A buyer of an European option that does not want to
wait for maturity to exercise it can sell the option to close the position.
What Does American Option Mean?
An option that can be exercised anytime during its life. The majority of
exchange-traded options are American. Since investors have the freedom
to exercise their American options at any point during the life of the contract, they are
more valuable than European options which can only be exercised at maturity.
What Does Asian Option Mean?
An option whose payoff depends on the average price of the underlying
asset over a certain period of time as opposed to at maturity. Also known as
an average option.
This type of option contract is attractive because it tends to cost less than regular
American options. An Asian option can protect an investor from the volatility risk that
comes with the market.
What Does Capital Asset Pricing Model - CAPM Mean?
A model that describes the relationship between risk and
expected return and that is used in the pricing of risky
securities.
Recent equity carve-outs in U.S. technology stocks appear to
violate a basic idea of financial theory: identical assets have
identical prices.
In our 1998–2000 sample, holders of a share of company A
are expected to receive x shares of company B, but the price of
A is less than x times the price of B.
A prominent example involves 3Com and Palm. Arbitrage
does not eliminate this obvious mispricing due to short-sale
constraints, so that B is overpriced but expensive or
impossible to sell short. Evidence from options prices shows
that shorting costs are extremely high, eliminating exploitable
arbitrage opportunities.
The efficient market hypothesis:
 
• it is not easy to earn excess returns.
• prices are “correct” in the sense that prices reflect fundamental
value.

If some firms have stock prices that are far from intrinsic value,
then those firms will attract too much or too little capital. That is why tests of
relative valuation, for example, using closed-end funds, are important.
LAW OF ONE PRICE

• The most basic test of relative valuation is the law of one price: the same
asset cannot trade simultaneously at different prices.
• The law of one price is usually thought to hold nearly exactly in financial
markets, where transactions costs are small and competition is fierce.
OBJECTIVE

• objective of this paper is to investigate violations of the law of one price, cases in
which prices are almost certainly wrong in the sense that they are far from the
frictionless price.
A notable example is Palm and 3Com.

• Palm, which makes hand-held computers, was owned by 3Com, a profitable company
selling computer network systems and services.

• On March 2, 2000, 3Com sold a fraction of its stake in Palm to the general public via an
initial public offering (IPO) for Palm.(Carve-out)

• In this transaction, called an equity carve-out, 3Com retained ownership of 95 percent

of the shares. 3Com announced that, pending an expected approval by the Internal
Revenue Service (IRS), it would eventually spin off its remaining shares of Palm to 3Com’s
shareholders before the end of the year.

• 3Com shareholders would receive about 1.5 shares of Palm for every share of 3Com
that they owned.
• this mispricing creates exploitable arbitrage opportunities. To the
contrary, the precise market friction that allows prices to be wrong,
namely shorting costs. These costs arise when short sales are either very
expensive or simply impossible. Although shorting costs are necessary in
order for mispricing to occur, they are of course not sufficient. Shorting
costs can explain why a rational arbitrageur fails to short the overpriced
security, but not why anyone buys the overpriced security.
 Sample of equity carve-outs:
in which the parent firm explicitly states its intention to immediately spin off its
remaining ownership in the subsidiary. In this case negative stubs appear to
present a trading opportunity with fairly clear timing. Spin-offs can be tax-free
both to the parent firm and to its shareholders.
Reasons why a firm might carve out before spinning off:
 The parent firm might want to raise capital for itself.
 The parent might wish to raise capital for the subsidiary to use.
 The parent might want to establish a dispersed base of shareholders in the
subsidiary for strategic reasons related to corporate control
 The parent might want to establish an orderly market for the new issue by
selling a small piece first

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The sample:
 Obtained from Securities Data Corporation a list of all carve-outs in which
the parent retains at least 80 percent of the subsidiary. Its list contains 155
such carve-outs from April 1985 to May 2000.
Constructing Stubs:
 the stub value: the ratio of subsidiary shares to be given to parent
shareholders at the distribution date.
 The ratio is the parent’s holdings of the subsidiary divided by the
outstanding number of shares of the parent on the record date of the
distribution.
 Concentrate on negative stubs in order to consider only cases of clear
violations of the law of one price.

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Time Pattern of Negative Stubs
Several patterns are apparent:
 First, stubs start negative and gradually get closer to zero, eventually becoming

positive.
 Second, the announcement of IRS approval and the consequent announcement

of a distribution date (occurring on the same day) cause the stub to go from
negative to positive in two cases, UBID and Palm.
 The picture is one of predictable idiosyncratic movement in stubs. Stubs start off

negative and then get positive. This pattern is repeated over time and does not
appear to reflect systematic exposure to some common factor, but rather
idiosyncratic developments. We draw two conclusions from the analysis so far.
 identified six cases of clearly negative stubs.

 the proportion of negative stubs, one-third of the cases studied, is particularly

significant. A negative stub indicates a gross case of mispricing. Even a single

case would raise important questions about market efficiency.
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Fig. 1.—Creative Computers/UBID stub, December 4, 1998–August 24, 199
Fig. 3.—3Com/Palm stub, March 2, 2000–September 18, 2000
Fig. 4.—Methode/Stratos stub, June 27, 2000–May 7, 2001
Fig. 2.—Stub values for HNC/Retek, Daiseytek/PFSWeb, and Metamor/Expedior
 Finding: the strategy of buying the parent and shorting the subsidiary produces high
returns with low (and largely idiosyncratic) risk.
 This investment strategy is related to several controversies in finance: value, IPOs, and the
diversification discount.
 First, it is a value strategy of buying cheap stocks and shorting expensive stocks.
 Second, it is a strategy that shorts IPOs. Ritter (1991) documents that IPOs tend to have
low subsequent returns, but the statistical soundness of this finding has been the subject
of a vigorous debate summarized in Fama (1998) and Loughran and Ritter (2000). In a
subset of the IPO debate, Vijh (1999) finds that carve-out stocks do not have low
subsequent returns.
 Third, it is a strategy that buys firms with a large diversification discount. Lamont and Polk
(2001) show that the diversification discount partially reflects subsequent returns on
diversified firms, so that the diversification discount does not reflect only agency concerns
such as wasteful managers.

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Returns on Stub Positions
 If an investor buys the parent and shorts an equal dollar amount of the
subsidiary, she gets a positive return of RP_ RS. In a frictionless market in
which the investor gets T T access to short-sale proceeds, this strategy is
a zero-cost or self-financing strategy. For this strategy, the exact
distribution ratio x is not important, as long as one knows that the stub
is negative initially. On paper, this strategy is an arbitrage opportunity,
since it has zero cost and generates strictly positive cash flow in the
future.

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Risks Specific to Stubs
 Since sample is so small, it is useful to discuss some events that did not
occur but might be expected to occur in a larger sample. Events that
might have a negative impact on arbitrage investors include canceling
the spin-off or changing the distribution ratio by lowering the number of
subsidiary shares that each parent shareholder receives. If the expected
ratio changes, then the stub can go from negative to positive without
any change in prices. Cancelation of the distribution can occur for
several reasons. First, if the firm does not receive IRS approval, the spin-
off is not tax-free and will probably be canceled. Second, the firm might
change its mind and cancel the spin-off even if the IRS does approve.
Another reason a distribution can be canceled is a takeover by a third
party or shareholder pressure.

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 The previous section argued that the negative stub situations
created very attractive investment opportunities. Why, then,
didn’t rational arbitrageurs step in to correct the mispricing by
buying the parent and shorting the subsidiary? There are many
types of reasons that in general might prevent rational investors
from correcting mispricing.
 These reasons include fundamental risk, noise trader risk, liquidity
risk, institutional or regulatory restrictions, and tax concerns. In
many situations, noise trader risk, institutional restrictions, and so
forth might cause assets to be mispriced. In our specific case,
however, these issues appear to be minimal, and the chief
impediment to arbitrage is short-sale constraints. First, shorting
can be simply impossible. Second, when shorting is possible, it can
have large costs.

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Description of the Shorting Process
 The market for shorting stock is not simply the mirror image of buying

stocks long, for various legal and institutional reasons. To be able to sell a
stock short, one must borrow it; and because the market for borrowing
shares is not a centralized market, borrowing can be difficult or
impossible for many equities.
 In order to borrow shares, an investor needs to find an institution or

individual willing to lend shares. Financial institutions, such as mutual

funds, trusts, or asset managers, typically do much of this lending.
 These lenders receive a fee in the form of interest payments generated

by the short-sale proceeds, minus any interest rebate that the lenders
return to the borrowers. Stocks that are held primarily by retail investors,
stocks with low market capitalization, and illiquid stocks can be more
difficult to short.

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Shorting Costs and Overpricing
 Short-sale constraints have long been recognized as crucial to the
workings of efficient markets. Diamond and Verrecchia (1987) describe a
model with some informed traders, other uninformed but rational
traders, and possible restrictions on shorting. In their model, although
shortsale constraints impede the transmission of private information,
short sale constraints do not cause any stocks to be overpriced.
Uninformed agents rationally take into account short-sale constraints
and set prices realizing that negative opinion may not be reflected in
trading.

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Evidence on Short Sales

Given the obvious nature of the mispricing in the cases of negative stubs and
the publicity associated with some of the cases such as Palm, it is not
surprising that many investors were interested in selling the subsidiaries short.
Short interest is much higher in subsidiaries than in parents, consistent with
the idea that the subsidiaries are overpriced. For parents, short interest
divided by total shares outstanding. For subsidiaries, short interest divided by
total shares sold to the public in the IPO, since these shares are the only ones
trading in the market.
Short-Selling Constraints: Evidence from Options
 Options can facilitate shorting, both because options can be a cheaper

way of obtaining a short position and because options allow short-sale

constrained investors to trade with other investors who have better
access to shorting.
 In a frictionless market, one expects to observe put-call parity. It should

hold exactly (within trading costs) for European options and

approximately for American options. One way of expressing put-call
parity is to say that synthetic shares (constructed using options plus
borrowing and lending) should have the same price as actual shares, plus
or minus trading costs such as the bid/ask spread.

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 This equality is just another application of the law of one price. A weaker
condition than put-call parity, which should always hold for non-dividend-
paying American options, is the following inequality: the call price minus the
put price is greater than the stock price minus the exercise price. For options
that are at-the-money (so that the option’s exercise price is equal to the
current price of the stock), this inequality says that call prices should be
greater than put prices. 

 For six cases with negative stubs, three had exchange-traded American
options within the relevant time frame: Xpedior, Palm, and Stratos. We used
weekly share prices and weekly options prices, as of 4:00 p.m. eastern time
on Friday.
 Cases studied are clear violations of the law of one price. Given that
arbitrage cannot correct the mispricing, why would anyone buy the
overpriced security? Why are some investors willing to buy shares in
Palm when there are cheaper alternatives available in the market, either
by buying the parent or by buying Palm synthetically in the options
market? In this section we investigate this question, first by asking a
simple question: Who buys the expensive subsidiary shares, and how
long do they hold them? We then look at IPO day returns for evidence
on how these investors affect prices of the parent.

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Investor Characteristics
 The first thing to note is that subsidiaries have turnover that is more
than five times that of parent turnover, with 37.8 percent of all tradable
shares turning over per day. Higher turnover means that subsidiary
shareholders have lower holding periods, and thus shorter horizons,
compared to parent shareholders. Non dealer shareholders of UBID, for
example, had an average horizon of two trading days, since turnover
was more than 100 percent (implying 50 percent turnover, with dealer
trades excluded).

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IPO Day Returns
 Hand and Skantz (1998), looking at carve-outs generally, provide
evidence that irrational investors can affect carve-out pricing. One
explanation is that optimistic investors who desire to hold the subsidiary
drive up the price of the parent on the announcement days and then
dump the parent in favor of the subsidiary on the IPO day.

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 There are two key findings of this paper that need to be understood as a
package:
 First, gross violations of the law of one price are observed.
 Second, they do not present exploitable arbitrage opportunities because
of the costs of shorting the subsidiary.
 In other words, the no free lunch component of the efficient market
hypothesis is intact, but the price equals intrinsic value component takes
another beating.

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• There is another interpretation, however, that is less rosy but more plausible.
We think that a sensible reading of our evidence should cast doubt on the claim
that market prices reflect rational valuations because the cases we have studied
should be ones that are particularly easy for the market to get right. Suppose
we consider the possibility that Internet stocks were priced much too high
around 1998–2000. The standard efficient markets reaction to such claims is to
say that this cannot happen.

• If irrational investors bid up prices too high, arbitrageurs will step in to sell the
shares short and, in so doing, will drive the prices back down to rational
valuations. The lesson to be learned from this paper is that arbitrage does not
always enforce rational pricing.
There is one law of economics that does still hold: the law of supply and
demand. Prices are set so that the number of shares demanded equals the
number of shares supplied. In the case of Palm, the supply of shares could
not rise to meet demand because of the sluggish response of lendable
shares to short. Similarly, if optimists are willing to bid up the shares of
some faddish stocks and not enough courageous investors are willing to
meet that demand by selling short, then optimists will set the price.