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428_lecture3_limitArbitrageA_stu_S09

# 428_lecture3_limitArbitrageA_stu_S09 - Limits to Arbitrage...

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Limits to Arbitrage AEM 428 Manny Dong Materials from Rosenthal & Young 1990; Froot & Dabora (1999) and Ming Huang’s notes

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What form Of MEH? What Does It Tell Us? Will January Be the Cruelest Month? WSJ 1/26/09
Limits to Arbitrage Valuation and arbitrage Siamese Twins Equity Carveouts Other evidence Implications of Limits to Arbitrage

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You have learned discounted cash flow model in your Finance class What is the meaning of DCF model? P = V ? ¢ Why do we think that the price of a project will equal the DCF value? ¢ Fundamentally, we do DCF because of arbitrage. 1 2 1 2 ..... (1 ) (1 ) (1 ) CF CF CF Value r r r = + + + + + +
Why do we think that the price of a project will equal the DCF value? Suppose we know what the future payoffs and the future discount rates will be for a security. If there is another security that has the same payoffs and the same risks, then it should be worth the same as this security. Then the security’s price should equal the DCF of the security. That’s the whole point of valuation.

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Arbitrage If there is an arbitrageur who is absolutely sure about her information and her view, she can buy and short the security infinitely when the price deviates from the discounted cash flow value. This should drive the price back to value.
Is price the same as value? P(security) = V(All CF paid by the security) Difficult to determine in the case of common stocks. Is the expected return calculated correctly? Is the cash flow estimated correctly? Joint hypothesis problem

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Law of One Price The Law of One Price (LOOP) states that identical securities – i.e., securities with identical cash flows - must have identical prices Corollary : a security with higher future cash flows should have a higher price • It is a fundamental law in modern finance theory – If it is violated, arbitrageurs are supposed to profit from the mispricing – It doesn’t depend on models of cash flow or discount rate
Case in point: Siamese Twins Royal Dutch vs Shell (Rosenthal and Young, 1990; Froot and Dabora, 1999)

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The Royal Dutch/Shell Group What is the organizational structure of the Group companies? Royal Dutch Petroleum and Shell Transport and Trading are linked by corporate charter, and shareholders receive cash flows in proportions 60/40.
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