onep

In the study of any subject , one starts with understanding basic principles / Laws. If it Physics, may be one starts off with basic laws governing universe, If it is Math, one starts with axioms , lemmas , theorems etc.
What about Finance and Economics, which are more of a social science than hard sciences ? Well, the first one is obviously, Demand and Supply Law..and then….most economists and folks from finance BELIEVE in “Law of One Price”, which says that identical goods must be priced the same. This is the law on which the mighty edifice of M-M capital structure is built, the BS Option pricing formula and Arbitrage pricing theory is built. However in the recent times, there have been a lot of anomalies to this law, a few examples are :

  • Closed-End Country Funds : The premium/discount spread commanded by these funds with respect to underlying has been very volatile and huge in actual magnitude

  • ADR: The spread between firm’s ADR and its domestic stock price

  • Twin Shares : Shares of firms which have 2 different stocks on the same asset / cash flows ( Royal Dutch/Shell) . Shouldn’t the spread be a function of their ownership on the underlying asset ..alas , not always the case

    In the cases mentioned above, there is some element of artificial barrier, like legal restrictions in investing , etc , some external factors that prevent arbitrage! good argument , but does it justify the huge premium that is being paid !

    But what about ?

  • Dual Class shares : Companies which issue dual class shares

  • Corporate Spin Offs

  • Statarb convergence trades :Converge trade of LTCM which blew

Takeaway :
Violations of Law of one price do not generally create arbitrage opportunities, they just create good but risky bets. Hence the new financial lexicon is beginning to grapple with “limits”, “risks”,“short-sale constraints” .

One can always discuss these special cases and still go with Law of One Price. But one needs to think why these anomalies are happening. To price Royal Dutch correctly versus Shell requires investors merely to multiply by 1.5, The same is true for other situations. If the market is flunking these no-brainers!, what else is wrong ?

This is why I start believing Mandelbrot’s arguments and his way of thinking. Still need to understand thoroughly Mandelbrots way in a clear way…All I know about it is from 10,000 ft …Little knowledge is good as NO knowledge….Need to find some time somehow and get going on Mandelbrot’s world.