On December 4th 1998, creative computer sold 20% of its online auction subsidiary “Ubid” in an IPO with intention to spin-off remaining 80% to shareholders of Creative in June 1999. One can show that given the ratio of the numbers of shares, each shareholder of Creative Computer will get about 0.715 shares of Ubid.
On December 9th 1998, Creative computer closing price was $22.75 and Ubid close was $35.6875.
A) According to traditional finance theory and assuming no frictions (transaction costs, taxes, or any other limitations) and full certainty (spin-off June 1999) what should be the relationship between the price of Creative computers and Ubid. Is this consistent with the December 9th 1998 prices?
B) You run ABC hedge fund, according to traditional finance theory and assuming no frictions (transaction costs, taxes, or any other limitations) and full certainty – what should you immediately do (describe your strategy)?
C) Assume real market conditions. Which frictions/ risks can limit your ability to execute your strategy (from B)? Name at least 2 frictions.
D) Summarize your answers (A, B and C) and relate them to the “Market Efficiency Hypothesis”.