U P D A T E
On December 23, 2008, GEF.B closed at a slight premium to GEF.
T H E S I S
This morning I noted the following quotes for GEF and GEF.B, respectively: $52.90 and $40.90. The correct arbitrage procedure is to sell one “A” Share for every 1.3 “B” Shares purchased so that the dollar value of each position is equal.
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Cog – Could you please go through the calculation used to know what ratio of a/b to short/buy. What are your assumptions as to the fair value spread – the liquidy premium in the a’s does have a value.
Thx
Asher,
I don’t know what the “correct” liquidity premium is, but I do know it is less than $12. At no time in the preceding five years has the spread exceeded $8 (until recently of course).
The arbitrageur should purchase the same dollar amount of GEF.B as he short sells of GEF. At current quotes this would mean 1.27 shares purchased for each share shorted: $5,399 / $42.50 = 127.
Cog –
THanks for the reply. In BBI and MWA i was under the impression the trade was to buy/short the same number of shares. However in GEf it is to buy/short the same market value of shares. Could you please explain how these situations are different? THanks!
A.E.
There is no difference between any of the transactions mentioned–it is always dangerous to buy and short an equal number of shares. The risk is patent when you consider this example: http://biz.yahoo.com/ts/081003/10440444.html?.v=1
The prescribed transaction would generate a loss of $2,000 if both classes were to double. If MWA.B were to increase 110% and MWA only 100% (resulting in a reduced spread), there would still be a loss of $1,400.
In the cases of MWA and BBI, it may have been satisfactory to buy and short an equal number of shares as the price of both classes declined. However this procedure is mathematically unsound–and tantamount to speculation.