Law of One Price
The law of one price is a fundamental concept of finance theory. According to this rule in an efficient market security must have a single price no matter how it is created. Recently, some puzzles have been discovered proving that the law of one price is violated.
This violation is so severe that prices are inconsistent with all valuation models. One example is security prices of “Siamese twin” shares, such as Royal Dutch Petroleum and Shell Transport and Trading. Twin shares trade at different places or in different countries and the division of current and future cash flows is fixed to each twin. The case of Royal Dutch Shell is a specific, well-known example in the related literature (Froot & Dabora, 1998, p2; Mullainathan & Thaler, 2000, p.7). The facts are that Royal Dutch Petroleum and Shell Transport are independently incorporated in the Netherlands and England respectively. The current firm emerged from a 1907 alliance between Royal Dutch and Shell Transport in which the two companies agreed to merge their interests on a 60:40 basis. Royal Dutch trades primarily in the US and the Netherlands and Shell trades primarily in London. According to rational models, the shares of these two components (after adjusting for foreign exchange) should trade in a ratio of 60:40. But they do not. The actual price ratio has deviated from the expected one by more than 35%. It does not make sense to explain this disparity with taxes and transaction costs. This is the violation of the law of one price rule (Froot & Dobora 1998, p.4; Glaser et al., 2003, p. 5). This is a simple, but well known example illustrating that prices can diverge from intrinsic value because of the limits of arbitrage. Some investors do try to exploit this mispricing, buying the cheaper stock and shorting the more expensive one, but this is not a sure thing, as many hedge funds learned in the summer of 1998 (Froot and Dobora 1998, p.4; Mullainathan and Thaler, 2000, p. 8).The second example of evidence against the rationality of market prices and law of one price was presented by Lamont and Thaler. They studied equity carve-outs by analyzing the spin-off of Palm, which was owned by 3Com. In March 2000, 3Com sold 5% of its Palm shares in an initial public offering and kept the remaining 95% of the shares. 3Com announced that its shareholders would eventually receive 1.5 shares of Palm for every 3Com share they owned. Accordingly, the stock price of 3Com had to be at least 1.5 times as high as the stock price of Palm, as long as the value of the whole 3Com company was positive. However, the stock price of Palm was far above the stock price of 3Com, implying a value of 22 billion U.S. dollars of 3Com's non-Palm business. Rational explanations of why arbitrage is not sufficient to avoid violations of the law of one price are examined at in the next subsection (Glaser et al., 2003, p. 5).