Summary: Something is amiss in the market for Citigroup securities: prices are out-of-whack with standard arbitrage relationships. This suggests that (a) recent financial turmoil — or, perhaps, the policy responses to it — have undermined market efficiency and (b) some investors are over-paying.
Recent weeks have witnessed yet another case of law-breaking in the financial sector: Citigroup is violating the law of one price.
When the market closed last Friday, there were at least three different ways you could invest in Citigroup’s common stock:
Simple: You could buy common shares of Citigroup, just as you would with any publicly-traded company.
Preferred: You could buy shares of preferred stock that will convert into common shares. Citi has announced, for example, that it intends to convert each share of Series F preferred into about 7.3 shares of common stock.
Synthetic: You could buy and sell options in a way that replicates the financial returns from owning Citi stock. For example, you could buy a call option with a strike price of $4, sell a put option with the same strike price, and set aside $4 in a bank account. Taken together, those investments will give you the same financial returns as owning a share of Citigroup common stock. (I am gliding over some small details here.)
In normal times, the law of one price would imply that you should pay nearly identical prices under any of these approaches. Transaction costs might allow prices to stray a bit from one another, and the preferred might trade at a small discount if the conversion isn’t completely certain. But any price differences should be small as arbitrageurs buy stock the inexpensive way and sell it the expensive way.
That isn’t the case today. Continue reading “The Citigroup Anomaly”