Citigroup & Efficient Markets

The Citigroup pricing anomaly may be in its final days (earlier posts here and here).

Investors must submit their offers to exchange preferred shares for common shares by this Friday (which may require contacting your broker several days earlier). The common shares will then be delivered to investors on July 30.

The pricing gap between the common and preferred shares remains large (about 10% at the close on Monday), but has narrowed as the exchange date has drawn near.

It thus seems an appropriate time to reflect on what, if anything, the Citigroup anomaly illustrates about economics and finance more broadly. Happily, this week’s Economist carries a quote from Dick Thaler (previously quoted in my post about Catherine Zeta-Jones) that summarizes the lesson perfectly:

Mr Thaler concedes that in some ways the events of the past couple of years have strengthened the [Efficient Markets Hypothesis]. The hypothesis has two parts, he says: the “no-free-lunch part and the price-is-right part, and if anything the first part has been strengthened as we have learned that some investment strategies are riskier than they look and it really is difficult to beat the market.” The idea that the market price is the right price, however, has been badly dented.

To me, the Citigroup anomaly illustrates the strength of the “no-free-lunch” part of the EMH, and the limitations of the “price-is-right” part. It has been clear for months that the prices of Citigroup securities cannot all be “right”. The price of common shares has persistently been been much higher than the equivalent price of preferred shares that are scheduled to convert. Some of that spread is normal, of course, as investors would demand some compensation for bearing the risk that the deal might fall apart. But the spread has been much wider than such risks could explain. As a result, I think the best explanation for the spread is that common shareholders, as a group, have been systematically overpaying for Citigroup common stock. Arbitrageurs, meanwhile, have been unable to arbitrage the spread away because of the high cost and difficulty of selling Citigroup short.

Despite this anomaly, my efforts to find a free lunch have been largely fruitless (so to speak). When short selling is difficult, the natural thing to do is to sell a deep-in-the-money call option (which is basically a common share), for example, or purchase a put option. But a thousand other investors have already thought of this, so the prices of those options already reflect that strategy, eliminating the obvious profit opportunities.

By the way, the expiration of the exchange offer does not necessarily mean the end of the Citigroup anomaly. The original anomaly involved three ways of buying common stock: directly, via the preferred, or synthetically via options. Once the dust settles on the exchange, it will be interesting to see whether the common price and the synthetic price are the same. If not, the anomaly will live on.

(FYI, Dick’s quote has already received lots of attention in the blogosphere, including: The Nudge Blog, Brad Delong, Overcoming Bias, and Matthew Yglesias.)

Disclosure: I have no investments in any Citigroup securities. (I closed out my small research position rather than deal with the exchange process.)

8 thoughts on “Citigroup & Efficient Markets”

  1. I’m confused, didn’t you ealier mention that a large institutional buyer was doing a term repurchase? Are you saying they are not getting a free lunch? I guess my question is you file this arbitrage, but isn’t that at odds with EMH if there is no free lunch? Or does the EMH say that there are no free lunches in the long-run?

  2. They are trying to get a free lunch. But to do so, they are undertaking a rare (unique?) approach of trying to do a repo with retail investors outside the usual channels of stock purchasing or borrowing. The wide spread between common and preferred is a big carrot that certainly invites innovation, but it’s clearly not a free lunch for normal investors. And if you need to create new financial approaches, it’s not a free lunch with the aspiring arbitrageuers either.

    Put another way, there may be a profitable lunch if you are sufficiently ingenious. And some other folks have undoubtedly made some money attempting versions of the trade for one reason or another. (For example, I made some money on my long preferred, short call options strategy, but I think a bunch of that was luck as the two securities bounced around an appropriate pricing relationship.)

  3. “Put another way, there may be a profitable lunch if you are sufficiently ingenious.”

    Right, but even then you have to put in time and effort to get that lunch, enough so that you’re working pretty hard for that lunch. And you probably need to be pretty talented, talented enough that you’d be pretty highly compensated in another field.

    So to put it another way, there’s no free lunch for amateurs. Professionals are able to work for lunch, though.

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