address these concerns we shall turn to the options market for additional
evidence on mispricing.
- Short-Sale Constraints and the Persistence of Mispricing
The previous section argued that the negative stub situations created very
attractive investment opportunities. Why, then, didn’t rational arbitrageurs
step in to correct the mispricing by buying the parent and shorting the
subsidiary? There are many types of reasons that in general might prevent
rational investors from correcting mispricing. These reasons include fun-
damental risk, noise trader risk, liquidity risk, institutional or regulatory
restrictions, and tax concerns. Shleifer and Vishny (1997) discuss idiosyn-
cratic risk and agency problems in delegated portfolio management (see
also Pontiff 1996). In the cases we study, the principal idiosyncratic risk is the
possibility that the distribution will not take place, and consistent with this
idea, when the distribution date is announced, the stub values sometimes
go from negative to positive. This pattern is consistent with arbitrageurs who
are reluctant to take on substantial idiosyncratic risk.
In many situations, noise trader risk, institutional restrictions, and so
forth might cause assets to be mispriced. In our specific case, however, these
issues appear to be minimal, and the chief impediment to arbitrage is short-
sale constraint. First, shorting can be simply impossible. Second, when
shorting is possible, it can have large costs.
A. Description of the Shorting ProcessThe market for shorting stock is not simply the mirror image of buying stocks
long, for various legal and institutional reasons. To be able to sell a stock
short, one must borrow it; and because the market for borrowing shares is
not a centralized market, borrowing can be difficult or impossible for many
equities. In order to borrow shares, an investor needs to find an institution
or individual willing to lend shares. Financial institutions, such as mutual
funds, trusts, or asset managers, typically do much of this lending. These
lenders receive a fee in the form of interest payments generated by the short-
sale proceeds, minus any interest rebate that the lenders return to the bor-
rowers. Stocks that are held primarily by retail investors, stocks with low
market capitalization, and illiquid stocks can be more difficult to short.
Being simply unable to short is particularly likely for individual retail
investors, although there is extensive anecdotal evidence of institutional
investors unable to short the overpriced subsidiaries. Regulations and
procedures administered by the SEC, the Federal Reserve, the various stock
exchanges, and individual brokerage firms can mechanically impede short-
selling, especially immediately after the IPO. In some cases, firms ask their
148 LAMONT AND THALER