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What does the Market Think?

What does the market think about IBM’s proposed acquisition of Sun?
Given the differences in size between the two companies it is definitely a case of “IBM + Sun = IBM.” Also, one might think that IBM being down over 2% in price (1:30pm Eastern March 18 2009: mid day after the news got out) on a neutral day (Dow down 0.5%, NASDAQ and S&P 500 up) is a strong vote against the merger. A more careful analysis shows that the market has not really expressed a strong opinion yet.

A lot of ink is spilled about the “information markets” but a lot of writers ignore just how much of the pricing of markets is due to information-free arbitrage and represents how markets work (and not information). For example the over 2% price decline in IBM actually tells us almost nothing- it is to be expected.

The quantity to look at is not price, but the total market value of IBM plus Sun.

If the market is in equilibrium Sun’s price should increase by an amount equal to the premium IBM is thought to be willing to pay for the stock times the perceived probability of the deal going through. Sun right now is $8.72 (up from $4.97) so it is safe to assume IBM is offering nearly a 100% premium on Sun stock and the market is fairly certain the deal will go through. So Sun’s total market cap (price per share times total number of shares) rose from $3.7 billion to $6.5 billion (or a net increase of $2.8 billion).

IBM’s price slid from $92.91 to $90.83 this means that its market cap fell from $124.7 billion to $121.9 billion or a loss of around $2.8 billion. Almost identical to the increase that priced Sun up 75%.

So the market is pricing IBM + Sun today very very closely to what the sum of prices yesterday. I would interpret this as yielding no information other than the fact that the market feels IBM will pay a substantial premium for Sun (and that the deal is likely to go through, yielding the 75% single day price in increase in Sun). The fact that the sum of market caps is so well preserved indicates that no big player has yet started trading on a strong opinion if the deal is good or bad.

All of the above arguments are “arbitrage-like.” The idea is if the market mis-priced the sum of IBM plus Sun then an informed trader could profit by taking an informed contrary position (it is not true arbitrage because the trader would have to take a risky position for a period of time) and waiting until some time after the merger finishes (or fails) to take a profit. Of course, as is now painfully obvious, all such arguments are irrelevant if the market locks up. Without a fluid market there is no reason for complicated combinations of investments to price lock step with each other.

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