Imagine that the money managers who invest MIT's endowment have come to you for advice. They tell you about a company, Smith Kline Beecham, which has two classes of stock: E and H. These two classes of stock are identical in terms of their voting rights and their claims on the profits (and potentially liquidation value) of the firm. All payouts (i.e., dividends) are equalized across the types of stock, so that one class E share must provide the same dividend flow as one class H share.
1. What does the efficient market theory predict about the relative prices of class H and E shares?
2. It turns out that the class H shares have traded at a price higher than the class E shares since the two classes were established. The money managers wants to know how to expolit this deviation. Describe an investment that will enable them to arbitrage the price deviation.
3. Write a short memo to the managers explaining the pros and cons of this arbitrage. What are the potential payoffs and what are the risks?