some other reason willing to hold overpriced assets. We shall refer to these
conditions collectively as “irrational,” but they could be anything that
causes a downward-sloping demand curve for specific stocks (despite the
presence of cheaper and nearly identical substitutes).^1 Thus two things,
trading costs and irrational investors, are necessary for mispricing. Trading
costs, by limiting arbitrage, create an environment in which simple supply
and demand intuition is useful in explaining asset prices. In our case, the
demand for certain shares by irrational investors was too large relative to
the ability of the market to supply these shares via short sales, creating a
price that was too high.
We investigate this question using all the cases we could find that share
the key elements of the Palm-3Com situation, namely a carve-out with an
announced intention to spin off the new issue in the near future. By limiting
ourselves to these cases (as opposed to the much larger category of all
carve-outs), we are able to minimize the risks that the spin-off never takes
place and thus reduce the risk inherent in the arbitrage trade.
We start in section 2 by describing carve-outs and spin-offs, showing
how we construct the sample and describing its main features. In section 3
we document high apparent returns that are implicit in market prices, de-
scribe relevant risks, and ask whether the high returns can plausibly be ex-
plained by risk. In section 4 we describe the short-sale constraints that
allow mispricing to persist. We document another notable departure from
the law of one price, the violation of put-call parity, and explain how this
departure is consistent with short-sale constraints. In section 5 we ask why
stubs become negative, look at IPO day returns on parents and issues, and
show the characteristics of investors in parents and issues.
2.Sample of Carve-outsWe examine carve-outs followed by spin-offs. An equity carve-out, also
known as a partial public offering, is defined as an IPO for shares (typically
a minority stake) in a subsidiary company. In an equity carve-out, a sub-
sidiary firm raises money by selling shares to the public and then typically
giving some or all of the proceeds to its parent. A spin-off occurs when the
parent firm gives remaining shares in the subsidiary to the parent’s share-
holders; no money changes hands.
134 LAMONT AND THALER
(^1) We use the term “irrational” for lack of a better word, but without wishing to engage in
any deep philosophical debate about rationality. If someone buys a stock or bets on a horse
because he or she likes the name and, in so doing, forgoes some financial benefit, we shall call
that irrational, regardless of whether the utility derived from owning the asset with this name is
large enough to compensate for the forgone financial advantage of owning a close substitute
with a less desirable name. Since our chapter concerns financial markets, it seems reasonable
to equate nonpecuniary with irrational.