ZAY Blog

For the past two days, we’ve witnessed one of what I would personally considered as the most hilarious jokes of the year unfolded on Wall Street.

Quick quiz to those of you who are reading this:

1. If a company that has not lost a single cent ever since it went public in 1999, and was labelled the most profitable firm in Wall Street, has reported a quarterly loss, how should the market react?

2. If the average of the analysts’ estimate of the loss is $3.73 per share, and the company ended up lost $4.97 per share, how should the market react (based on either the Arbitrage Price Theory that I am sure every single finance student would know, or simply your guts feeling?)

I guess the most common answer would be the decline in share price.

And that happened to Goldman Sachs yesterday.

And GS rallied 15% yesterday.

It was interesting to see how the helpless financial news reporters say about this. The editors in Bloomberg, after scratching their heads for hours, came up with the excuse that the performance was better than the most pessimistic estimate from an analyst in UBS AG, who was predicting $5.50 per share loss (I bet all those shorters want to beat the hell out of that guy now). (http://www.bloomberg.com/apps/news?pid=20670001&refer=&sid=a6ku8xZK62X0) New York Times, being more political, simply said that it was “in line” with analysts’ estimates (OK, perhaps my English is really bad, but do English-speaking community generally consider miss by 33% from average as “in-line”?)

And the story did not end here.

This morning, Morgan Stanley reported its quarterly loss.

And this time, the average from analysts was 34 cents per share loss, with no estimate more than $1.15, according to Bloomberg.(http://www.bloomberg.com/apps/news?pid=conewsstory&refer=conews&tkr=MS%3AUS&sid=aKpeqFFx_giU)

The results was $2.24 per share loss.

Interesting enough, the share of MS rallied as much as 9.14% at one point of time before closing at 2.3% rise.

Now the most interesting part came, as both Bloomberg and New York Times found themselves in a awkward position that they could no longer explain the reason for such spike.

And their strategy was simple: based on facts. They simply reported the loss with no analysis/explanations.

In front of me is a copy of the shareholder’s prospectus on the Wachovia and Wells Fargo merger.

Put all the excitement aside (since this is the first time I am voting as a shareholder for a legal entity, although practically I do not hold any stock of Wachovia Corp as this point although I held an insignificant portion of Wachovia Corp common shares as of the recording date), I can not help to wondering whether there is any arbitrage opportunity arises here.

On the prospectus, it was stated that the merger was publicly announced on the 3 October, 2008 and the criteria of the merger is that each of the Wachovia common stock will be converted into 0.1991 of a share of Wells Fargo common stock. Using the law of one price, or the no-arbitrage principle, one should expect the common shares of Wachovia to be traded at 0.1991 times of the Wells Fargo stock. However, a simple Excel spreadsheet would reveal that is not the case.

The following table summarized the daily closing price of Wachovia Corp. (NYSE: WB) relative to the daily closing price of Wells Fargo (NYSE: WFC) from 2 October, 2008 to 12 December, 2008:

Average: 0.18468

St Dev: 0.018232

Count: 52

>0.1991:1

=0.1991:0

<0.1991:51

In the 52 trading days of data available, there is only one day that the share price of Wachovia Corp traded above 0.1991 times of that of Wells Fargo, and the average is slightly below 0.1991, at around 0.1846.

In the textbook, we learnt that in this case, the shares of Wells Fargo is overvalued and the shares of Wachovia Corp is undervalued and we should go short on WFC and long on WB.

However, why such “arbitrage” opportunity has existed for so long if, in theory, the market is efficient enough (the market in reality is a combination of semi-strong efficient and weakly efficient) to balance the demand and supply curve?

In my opinion, there are 2 major issues here
1. The uncertainty of merger. Although almost all major shareholders of Wachovia Corp have mostly accepted the fate of the bank, there are still shareholders who are contending for the merger, claiming that the merger has significantly undervalued the firm. It is very unlikely, but still possible, that such lawsuits will cause the merger to fail.

2. The volatility in the stock market: Although the shareholder’s meeting is going to take place on December 23, 2008, the merger is not expected to be completed  on that day. As a result, there may still be volatility in the share prices of both WFC and WB, which could affect the implied values of the shares.

Note that the market was able to quickly absorb the information and the ratio was relatively stable after the initial fluctuation, indicating the market is still fairly efficient despite that there was significant arbitrage opportunity initially even after the announcement was made to public.

However, it was also noted that out of those 52 days, in 44 days both shares went up and down together, hence it is safe to say that the market has indeed absorbed the information of the merger and is currently considering the two corporations as a pair rather than two unrelated stocks. When comparing to S&P 500 index (which is the proxy for the market portfolio), WB was traded with the movement of the market in only 27 out of the 52 days, indicating that is quite independent of the market movement.

Recently, I’ve been following very closely with the case of Societe Generale and now-infamous trader Jerome Kerviel, who is been blamed for causing close to 5 billion Euros of loss as a result of trading on futures contact.

I was amazed, honestly, by the fact that he was able to, single-handedly (although this is being disputed at the time this article is written), build more than 50 billion Euros position within a couple of years, supposedly went unnoticed.

And he actually made some profit (about 1.4 billion Euros) before taking the big hit due to the recent recession of World economy.

And what he did was strikingly similar to what George Soros, the greatest hedging fund manager and the man who broke the Bank of England, did, back in 1992.. (Well, minus the part of computer hacking and so on).

Both were trading futures contracts, both spotted an arbitrage opportunity that others would probably think that was insane, both were playing around with the tiny margin of exchange rates, and both were building positions that were multiple times of their limit (Soros borrowed most of the 10 billion he used to short sale Lira and Pounds, among several positions that he has hedged against other currencies).

The only difference is that back in 1992, risk management was very little known and since Soros was the boss, he was allowed to take such a risky move.

And George Soros made the right bet, and earned a billion in 24 hours, but the unfortunate Jerome Kerviel did not, and lost about 5 billions.

And George Soros became the most successful fund manager in the world, and Jerome Kerviel become the newest criminal and possibly will be condemned for the rest of his life.

As we all know, large profit will only come as a result of large risk, and from the investors perspective, the higher the profit, the better.

If that were to be the case, why should we hate Jerome Kerviel while we worship (to a certain extent) George Soros?

And the bigger question is: did we, in the midst all the regulations and risk control processes, accidentally “kill” many more potential risk-takers who could potentially become the next most successful fund manager?

To me, Jerome Kerviel is just an unfortunate genius, who, perhaps should be born 20 years earlier.