Price Deviation Supported by Arbitrage: Evidence from Family Business Groups

• Author: Shu‐Feng Wang,Woojin Kim
• Date: 01 June 2019
• Published date: 01 June 2019
• DOI: http://doi.org/10.1111/ajfs.12259

Price Deviation Supported by Arbitrage:

Evidence from Family Business Groups*

Woojin Kim

Seoul National University Business School, Republic of Korea

Shu-Feng Wang**

School of Business, Ajou University, Republic of Korea

Received 27 September 2017; Accepted 17 October 2018

Abstract

This paper examines how arbitrage may contribute to, rather than remove, temporary price

deviation between two related securities. Based on a unique sample of stock-for-stock tender

offers by a member firm for another member firm within Korean family business groups, we

find that arbitrage opportunity exists in more than three quarters of the sample, which is con-

sistent with Lamont and Thaler (2003). Outside investors’ tendering decisions and institutions’

short-selling are consistent with exploiting potential arbitrage opportunities, but not large

enough to eliminate them. The prices of the two securities tend to diverge leading up to the

tender offer, which may be impacted by the controlling families. This deviation, reflected in the

exchange ratio of the two securities, is more likely to be sustained when there is more short-

selling during the possible arbitrage period. Our results suggest that arbitrage may support tem-

porary deviations in the relative prices of two related securities under certain circumstances.

Keywords Business group; Limits to arbitrage; Mispricing; Korea

JEL Classification: G14, G15, G34

1. Introduction

A key premise in financial economics is that mispricing in securities does not last

for long due to arbitrage activities. Whenever market prices deviate from firms’

fundamental values, arbitrage is expected to move them back towards those values.

Empirically testing such an implication, however, is far from trivial since funda-

mental values are not observable. As such, empirical identification relies on the

*Woojin Kim is grateful to the Institute of Management Research and the Institute of

Finance and Banking at Seoul National University for their financial support. This work was

supported by the new faculty research fund of Ajou University. All errors are our own.

**Corresponding author: School of Business, Ajou University, 206 Worldcup-ro, Yeongtong-

gu, Suwon 16499, Korea. Tel: +82-31-219-2913, Fax: +82-31-219-1616, email: sfwang@

ajou.ac.kr.

Asia-Pacific Journal of Financial Studies (2019) 48, 362–385 doi:10.1111/ajfs.12259

362 ©2019 Korean Securities Association

relative values of similar securities, for example, closed-end funds, ADRs (American

Depository Receipts), or Siamese twins like Royal Dutch and Shell.

Studies that examine prices of two similar securities mostly focus on whether

arbitrage activity reduces the gap between the two prices. Lamont and Thaler

(2003) describe an interesting circumstance where investors of parent firms receiv e

a fixed amount of carved-out subsidiary shares at a later date. Since there is clearly

a defined exchange ratio between the two securities soon to be realized, the stan-

dard no arbitrage argument predicts that the prices of the two securities will move

in accordance at the pre-defined exchange ratio. However, Lamont and Thaler

(2003) show that the market prices of subsidiary stocks far exceed those implied in

the pre-defined ratio, essentially violating the law of one price, and attribute such

‘blatant’ mispricing to limits of arbitrage, or more specifically limits to short sales.

In this paper, we extend the previous research on relative mispricing and examine

a unique setting where arbitrage may be feasible based on the price differential

between two related securities. Specifically, we examine a sample of family business

groups in Korea that underwent a series of transactions involving a spin-off followed

by a stock-for-stock tender offer that ultimately results in a parent–subsidiary rela-

tionship between the two spun-off firms. The literature has widely recognized the

prevalence of family-controlled business groups in Korea, or chaebols, and their impli-

cations

1

In their effort to cooperate with regulatory initiatives to streamline their com-

plex inter-corporate shareholding structure, some have changed their group-level

organization structure into holding companies through this two-step procedure.

Since our sample transactions involve a stock-for-stock tender offer at pre-de-

fined exchange ratios to be realized at a later date, investors face a potential arbi-

trage opportunity similar to those available in mergers or equity carve-outs

followed by spin-offs, as introduced in Lamont and Thaler (2003). However, since

our transactions are made within business groups, not at arm’s length, they are

quite different from both conventional merger arbitrages and the Lamont and Tha-

ler (2003) sample in the following respects.

First, merger arbitrage is generally considered risky, because of some possibility

that the merger deal —between two independent parties —may not go through,

such that the exchange ratio between the two securities does not materialize. In our

sample, however, the transactions are coordinated at the business group level, and so

there is very little, if any, possibility of the exchange ratio not being realized. Thus,

arbitrage opportunities embedded in our sample are closer to those in Lamont and

Thaler (2003), but much less risky than conventional merger arbitrage.

2

1

see, La Porta et al. (1999), Bae et al. (2002), Baek et al. (2006), among many others.

2

The only risk is the possibility that the tender offer may fail due to a small number of ten-

dered shares that fall short of the sought-after number of shares. However, this is less likely

since the controlling family is likely to tender its shares in the subsidiary in exchange for new

shares of the holding company.

Price Deviation Supported by Arbitrage

©2019 Korean Securities Association 363