Prof. Jayanth R. Varma's Financial Markets Blog

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Prof. Jayanth R. Varma's Financial Markets Blog, A Blog on Financial Markets and Their Regulation

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Tue, 30 Oct 2012

Purported solution of Palm-3Com relative pricing puzzle

Martin Cherkes and Chester Spatt claim in a recent paper to have solved the puzzle about the relative pricing of Palm and 3Com. During the dot com bubble, 3Com sold 5% of its Palm subsidiary to the public, and announced its intention to spin off the remaining 95% to its shareholders. The market valued the common stock portion of Palm owned by 3Com at more than the whole of 3Com implying a negative value (-$22 billion) to the residual business of 3Com. This was implausible because 3Com had positive value before it acquired Palm, and after the spin off was complete, the residual part of 3Com was valued at $5 billion.

Cherkes and Spatt “solve” this problem by using the forward price of the Palm share instead of the spot price. Of course, single stock futures were not available in the US in those days; so they use synthetic futures prices computed from the options market (long call plus short put). The forward price is well below the spot price and based on this price, 3Com appears to be correctly valued. They also showed that as changes in the expected spin off date altered the maturity of the required synthetic future, all the relative prices adjusted to keep the valuation correct.

This is definitely an important addition to what we know about the 3Com puzzle – at the very least, it shows that the no arbitrage conditions and the law of one price were satisfied even at the peak of the dot com frenzy. But I do not believe that this is a complete solution. It is a little like claiming to solve the uncovered interest parity puzzle by pointing out that covered interest parity does hold. Yes, it is nice to know that covered interest parity is not violated and there are no risk free arbitrage opportunities available. But this only substitutes one problem for another: the forward rate is now biased and one has to appeal to some kind of time varying risk premium to explain this away.

The same problem does come up here. How does one justify the depressed forward price of the Palm stock? Cherkes and Spatt argue that this is explained by the securities lending fees that could be earned on the Palm stock. These fees arise because rational investors want to short Palm stock and buy 3Com to arbitrage the difference away. Since there are too few Palm stocks available (only 5% of the shares have been sold to the public), what happens is that the lending fees rise to the point where the arbitrage is no longer available. This is just like the currency forward premium rising till it equals the interest differential and the risk free arbitrage opportunity is eliminated.

The fundamental problem remains – either or both of the Palm and 3Com stock were mispriced. As usual, the “there is no free lunch” version of the Efficient Markets Hypothesis holds, but the “prices are correct” version fails.

Posted at 11:39 on Tue, 30 Oct 2012     View/Post Comments (0)     permanent link

Fri, 26 Oct 2012

Selective Price Sensitive Disclosure by Government Functionaries

I was mulling over the interesting paper on “Selective disclosure by federal officials and the case for an FGD (Fairer Government Disclosure) regime” by Donna M. Nagy and Richard W. Painter when I came across this bombshell from the Chair of the UK Statistics Authority to the Prime Minister of the UK (h/t FT Alphaville):

I was made aware during the course of yesterday afternoon of your remarks at Prime Minister’s Questions in respect of the economy, in particular your statement that “the good news will keep coming”. This was ahead of this morning’s Office for National Statistics release of the preliminary estimate of Gross Domestic Product for the third quarter of 2012, to which you receive pre-release access up to 24 hours ahead of publication.

... The Pre-Release Access to Official Statistics Order 2008 states that recipients of pre-release access must not disclose ‘any suggestion of the size or direction of any trend’ indicated by the statistic to which the recipient has been given such access. It is clear from media reports that, although this may not have been your intent, your remarks were indeed widely interpreted as providing an indication about the GDP figures.

This episode is yet another reminder that the selective release of price sensitive information by government functionaries is a serious problem. Nagy and Painter propose that government functionaries must be subject to a regime of fair disclosure similar to that imposed on corporate insiders by Regulation FD in the US. (They explain that the recently enacted STOCK Act that deals with insider trading by members of the US Congress does not deal with selective disclosure.) Nagy and Painter also point out that there are a number of legal problems in creating such a regime because of the enhanced constitutional protection to communications between federal officials and members of the public because “speech on public issues occupies the highest rung of the hierarchy of First Amendment values, and is entitled to special protection.” But they believe that a Fair Government Disclosure regime can be created that addresses these concerns.

In India also we have seen selective (and even misleading) disclosure of information by government functionaries. There is a need to develop mechanisms to reduce the chance of such events.

Posted at 19:02 on Fri, 26 Oct 2012     View/Post Comments (0)     permanent link

Fri, 19 Oct 2012

Luddites in technology company finance departments

I was fascinated by yesterday's fiasco in which Google filed its draft earnings statement with the SEC prematurely – the principal giveaway was a press release that said right at the top “PENDING LARRY QUOTE”. Several newspapers reported a statement from Google stating:

Earlier this morning RR Donnelley, the financial printer, informed us that they had filed our draft 8K earnings statement without authorization. We have ceased trading on NASDAQ while we work to finalize the document. Once it's finalized we will release our earnings, resume trading on NASDAQ and hold our earnings call as normal at 1:30 PM PT.

Interestingly, this statement is nowhere to been seen at the Google Investor Relations web site or in the SEC filings. Obviously, Regulation FD does not cover everything! raises the very interesting question as to why Google would use RR Donnelley to file its financial statements. This was the same thought that came to my mind – surely, a company whose software can navigate driverless cars, or translate automatically from one language to another, or find almost anything that there is on the vast world wide web should not find it too hard to click the “Send” button.

But Google is not alone in this. Some of India's largest technology companies who make money by running the most challenging business processes for their clients, turn to RR Donnelley to file their financial statements with the SEC. This is part of a broader phenomenon that I see all the time. Technology companies which use very sophisticated information technology in their core operations often have a fair share of Luddites in their corporate finance departments.

I am reminded of an episode almost an eternity ago, when some of my coffee loving colleagues and I were stuck in one of India's largest coffee plantations. My colleagues spent the better part of a day driving around the whole place in search of a cup of fresh coffee. It was all in vain; the management of the coffee plantation had not yet given up the old colonial mindset in which tea was the beverage of choice, and coffee was only something that you sold to make your money. The attitude in technology company corporate finance departments is very similar – technology is something to be monetized and not necessarily to be used.

Posted at 11:37 on Fri, 19 Oct 2012     View/Post Comments (0)     permanent link

Sat, 13 Oct 2012

Predictable unpredictable numbers compromise Chip and PIN cards

A group of researchers at the University of Cambridge have a paper describing serious security weaknesses in Chip and PIN or EMV cards (h/t Bruce Schneier). EMV or “Chip and PIN” which is the leading system for card payments world-wide contains a chip that executes an authentication protocol. This protocol requires point-of-sale (POS) terminals or ATMs to generate an unpredictable number for each transaction to ensure it is fresh. The ATM sends this unpredictable number to the card along with various transaction fields. The card responds with an authorization request cryptogram (ARQC), which is calculated over the supplied data. If properly implemented this ARQC allows the ATM or POS to verify that the card is alive, present, and engaged in the transaction.

The reality is very different. The Cambridge researchers discovered that some EMV implementers have merely used counters, timestamps or home-grown algorithms to supply the “unpredictable” number which is the heart and soul of the entire protocol. Moreover, the fault actually lies with the EMV designers themselves:

The first flaw is that the EMV protocol designers did not think through carefully enough what is required for it to be “unpredictable”. The specifications and conformance testing procedures simply require that four consecutive transactions performed by the terminal should have unique unpredictable numbers ... Thus a rational implementer who does not have the time to think through the consequences will probably prefer to use a counter rather than a cryptographic random number generator (RNG); the latter would have a higher probability of failing conformance testing (because of the birthday paradox).

If the “unpredictable number” can actually be predicted, it is possible to perform all kinds of “pre-play” attacks. A crooked merchant can harvest an ARQC while having custody of the card in his POS termimal and than replay this at an ATM without the card being present and execute transactions there.

The researchers conclude:

Just as the world’s bank regulators were gullible in the years up to 2008 in accepting the banking industry’s assurances about its credit risk management, so also have regulators been credulous in accepting industry assurances about operational risk management.

Posted at 21:41 on Sat, 13 Oct 2012     View/Post Comments (0)     permanent link