CHAPTER 26: HEDGE FUNDS

CHAPTER 26: HEDGE FUNDS

PROBLEM SETS
14
And
Problem 1. On July 6, 1998 Creative Computers (MALL) have announced an equity
carve-out IPO of their subsidiary U-Bid (UBID). The IPO took place after trade close on
December 3, 1998. There were approximately 20% of U-Bid shares offered in the IPO,
with the remaining 80% of the shares being held in the parent company and to be
distributed 6 months after the IPO to the parent company's shareholders in a tax-free
spinoff subject to the favorable IRS ruling. UBID sold 1.87 million shares in the IPO at
$15 per share. The total of UBID shares (sold in the IPO and held within the parent) is
9,146,883. The parent company, MALL, had 10,238,703 shares outstanding at the time.
The IPO took off very strongly with UBID shares closing at $48 on the first day of
trading. On December 9, 1998 at the end of the day MALL was trading at $22.75 and
UBID was at $35.69. Answer the following questions:
a.

What are the market valuations of MALL and UBID as of December 9th?

b.

Do these market valuations seem right to you? Explain.

c.

Suggest an arbitrage position (portfolio) in MALL and UBID which would make
money if the tax-free spinoff of UBID shares to MALL shareholders occurs. You
can be long/short in any of the two stocks. Hint: "buy low sell high", but figure the
right hedge ratio (i.e., how many MALL shares one needs to buy (short) when he
shorts (buys) one share of UBID, or how many UBID shares one needs to buy
(short) when he shorts (buys) one share of MALL) first!

d.

Suppose you have $20,000,000 ($20M) of investable capital. You can buy shares
on the margin and sell shares short. Initial margin is 50% and maintenance margin
is 30% for both short and long positions. Suppose you decided to keep $1M as
reserve cash and use the remaining $19M to invest in risk-arbitrage you suggested
in the previous homework. Using the closing prices from the spreadsheet on
December 4, 1998 (file linked on the class page) calculate the number of basic
arbitrage positions you can support with your collateral. Use the margin
purchase for long position, not just cash, to the extent allowed. Calculate the
number of shares in your short and long position.
Follow USRX-COMS example and first calculate the amount of money you have
to pay for one basic arbitrage position discussed in the answer to homework #1,
then find the number of basic positions you can support with $19M.

e.

Suppose your broker ignores margin requirements, what would have been the
total profit AND return on this position when the convergence occurred after
close of the trade on June 7, 1999? Use closing prices on June 8 from the

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Appendix:
CHAPTER 26: HEDGE FUNDS
PROBLEM SETS
14

CHAPTER 26: HEDGE FUNDS

spreadsheet to compute the answer here (these are the earliest prices available in
the spreadsheet when UBID is no longer a part of MALL).
f.

Suppose that broker is watching the margins. What is the first day that your
account hits margin call? (To figure this out you have to use aggregation of short
and long positions on one account as we discussed in class using the example on
the handout distributed in class. Also use the example spreadsheet with USRX
and 3COM arbitrage from the class web page.) Is $1,000,000 large enough buffer
to answer this first margin call? What would be the return if the positions were
closed on that day? You can use as an example USRX-COMS file to track margin
requirements. It has to be modified for a different conversion ratio.

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