aem428 hw 2 - Siming Zhu February 13, 2008 AEM 428 -...

Info iconThis preview shows pages 1–2. Sign up to view the full content.

View Full Document Right Arrow Icon
Siming Zhu February 13, 2008 AEM 428 - Problem Set 2 1) XYZ (trading in US) is currently trading at a significant discount to its Siamese twin stock ZYX which trades in UK. You can observe XYZ trading at a discount stock price relative to ZYX’s stock price. (a) If you have an infinite trading horizon, is there a riskless arbitrage opportunity? Explain. Assume no transaction costs, no management fees, full use of short-sale proceeds, and also assume that the closed end funds passes all dividends through to the investor immediately. If there is an infinite trading horizon, there would be a riskless arbitrage opportunity. To exploit this opportunity, an arbitrageur would short ZYX (the expensive stock) and buy XYZ (the discount stock). Since XYZ and ZYX are Siamese twin stocks, they are very good substitutes for each other, and thus hedge the fundamental risk associated with the position. Being Siamese twin stocks, any news released by the parent company should affect the two stocks equally, thus hedging fundamental risk. By shorting ZYX, the arbitrageur will lock in an immediate profit with which he can use to buy shares of XYZ (the discount stock). Since there is an infinite trading horizon with full use of short sale proceeds and no cost/ fees for short position, the arbitrageur does not have to worry about noise-trader risk either. Even if the prices of the twin stocks continues to diverge, with an infinite trading horizon and no costs, the arbitrageur can just wait for the stocks to eventually converge and realize a profit by selling XYZ and using the profits to cover his short position (ZYX). (b) If you have a finite trading horizon, is there a riskless arbitrage opportunity? Explain. Assume no transaction costs, no management fees, full use of short-sale proceeds, and also assume that the closed- end funds passes all dividends through to the investor immediately. If there is a finite trading horizon, then there will not be a riskless arbitrage opportunity. The prices of XYZ and ZYX may not converge in the short term; mis-pricing may get worse due to noise trader risk (market becomes more inefficient), which will lead to steep losses if the arbitrageur is forced to liquidate his position before convergence. (c) What is the basic economic reason why arbitrageurs tend to have short trading horizon? The explanation for the short trading horizons of arbitrageurs is that there is a principle/agency problem. Arbitrageurs are generally not individual investors, but professional money managers who manage the money of other people. Thus, there is a separation between brain (arbitrageur) and money (investor). If the arbitrageur manages a hedge fund that takes on short positions, then investors of the hedge fund may withdraw their money if they see that the positions the arbitrageur has taken on has lost a significant amount of money. If enough investors do this, then it will force the arbitrageur to liquidate their positions prematurely at a loss. Also, the shares that arbitrageurs short are generally borrowed shares.
Background image of page 1

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon
Image of page 2
This is the end of the preview. Sign up to access the rest of the document.

Page1 / 6

aem428 hw 2 - Siming Zhu February 13, 2008 AEM 428 -...

This preview shows document pages 1 - 2. Sign up to view the full document.

View Full Document Right Arrow Icon
Ask a homework question - tutors are online