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A blog on financial markets and their regulation
Martin Cherkes and Chester Spatt claim in a recent paper to have solved the puzzle about the relative pricing of Palm and 3Com. During the dot com bubble, 3Com sold 5% of its Palm subsidiary to the public, and announced its intention to spin off the remaining 95% to its shareholders. The market valued the common stock portion of Palm owned by 3Com at more than the whole of 3Com implying a negative value (-$22 billion) to the residual business of 3Com. This was implausible because 3Com had positive value before it acquired Palm, and after the spin off was complete, the residual part of 3Com was valued at $5 billion.
Cherkes and Spatt “solve” this problem by using the forward price of the Palm share instead of the spot price. Of course, single stock futures were not available in the US in those days; so they use synthetic futures prices computed from the options market (long call plus short put). The forward price is well below the spot price and based on this price, 3Com appears to be correctly valued. They also showed that as changes in the expected spin off date altered the maturity of the required synthetic future, all the relative prices adjusted to keep the valuation correct.
This is definitely an important addition to what we know about the 3Com puzzle – at the very least, it shows that the no arbitrage conditions and the law of one price were satisfied even at the peak of the dot com frenzy. But I do not believe that this is a complete solution. It is a little like claiming to solve the uncovered interest parity puzzle by pointing out that covered interest parity does hold. Yes, it is nice to know that covered interest parity is not violated and there are no risk free arbitrage opportunities available. But this only substitutes one problem for another: the forward rate is now biased and one has to appeal to some kind of time varying risk premium to explain this away.
The same problem does come up here. How does one justify the depressed forward price of the Palm stock? Cherkes and Spatt argue that this is explained by the securities lending fees that could be earned on the Palm stock. These fees arise because rational investors want to short Palm stock and buy 3Com to arbitrage the difference away. Since there are too few Palm stocks available (only 5% of the shares have been sold to the public), what happens is that the lending fees rise to the point where the arbitrage is no longer available. This is just like the currency forward premium rising till it equals the interest differential and the risk free arbitrage opportunity is eliminated.
The fundamental problem remains – either or both of the Palm and 3Com stock were mispriced. As usual, the “there is no free lunch” version of the Efficient Markets Hypothesis holds, but the “prices are correct” version fails.