The Stock Market 8-9
unanticipated negative news drives the price of General Motors stock
Noise trader risk. A noise trader is someone whose trades are not based
on information or financially meaningful analysis. Noise traders could, in
principle, act together to worsen a mispricing in the short run. Noise trader
risk is important because the worsening of a mispricing could force the
arbitrageur to liquidate early and sustain steep losses. Noise trader risk is
also called sentiment-based risk.
Implementation costs. These costs include transaction costs such as bid-
ask spreads, brokerage commissions, and margin interest. In addition,
there might be some short-sale constraints.
B. The 3Com/Palm Mispricing
On March 2, 2000, 3Com sold 5 percent of one of its subsidiaries to the public
via an IPO. At the time, the subsidiary was known as Palm. 3Com planned to
distribute the remaining Palm shares to 3Com shareholders at a later date.
Under the plan, if you owned 1 share of 3Com, you would receive 1.5 shares of
Palm. So, after 3Com sold part of Palm via the IPO, investors could buy Palm
shares directly, or they could buy them indirectly by purchasing shares of 3Com.
What makes this case interesting is what happened in the days that followed the
Palm IPO. If you owned one 3Com share, you would be entitled, eventually, to
1.5 shares of Palm. Therefore, each 3Com share should be worth at least 1.5
times the value of each Palm share. We say “at least” because the other parts of
3Com were profitable.
As a result, each 3Com share should have been worth much more than 1.5 times
the value of one Palm share. But, things did not work out this way. The day
before the Palm IPO, shares in 3Com sold for $104.13. After the first day of
trading, Palm closed at $95.06 per share. Multiplying $95.06 by 1.5 results in
$142.59, which is the minimum value one would expect to pay for 3Com. But the
day Palm closed at $95.06, 3Com shares closed at $81.81, more than $60 lower
than the price implied by Palm.
A 3Com price of $81.81 when Palm is selling for $95.06 implies that the market
values the rest of 3Com’s businesses (per share) at $81.81 − $142.59 = −$60.78.
Given the number of 3Com shares outstanding at the time, this means the
market placed a negative value of about −$22 billion for the rest of 3Com’s
businesses. Of course, a stock price cannot be negative. This means, then, that
the price of Palm relative to 3Com was much too high.
To profit from this mispricing, investors would purchase shares of 3Com and
short shares of Palm. In a well-functioning market, this action would force the
prices into alignment quite quickly.
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