hedge fund might speculate (short-term) in the offering, invest (medium- or
long-term) in the new technology, or sell short a overpriced offering.
The techniques used to analyze spin-offs involve standard equity valu-
ation methods. The hedge fund has divisional data, perhaps available for
the first time as pro forma financial statements. The division can be valued
using discounted cash flow analysis and by comparing the newly indepen-
dent division to comparable companies in the same sector.
Equity Market Neutral--Pairs Trading
The pairs trading strategy begins as the most intuitive of equity trading.
Identify two equity issues that should track one another closely. Then look
for times when the issues fail to track one another.
In its purest form, the pairs strategy involves different issues of the
same company. For example, Berkshire Hathaway has two classes of
shares that differ in minor ways except that class B shares own one thirti-
eth as much of the company as class A shares. The shares should behave
nearly identically, adjusted for the proportional difference in value.
Another example of a pairs combination is the American depositary
receipt (ADR) market. For example, shares of Sony trade in Tokyo in the
local currency. Shares of ADRs supported by shares of Sony trade on the
New York Stock Exchange in U.S. dollars. The value of the shares in
Tokyo differs from the value of the shares in New York primarily because
of the exchange ratio between the Japanese yen and the U.S. dollar. A
pairs trading strategy might involve buying the shares in one market, sell-
ing the equivalent amount short in another market, and hedging the cur-
rency exposure.
As the match between the long and short shares becomes looser, the
number of trading opportunities increases along with the risk. Some com-
panies have multiple classes of shares, reflecting different business lines. A
pairs trade between these shares relies on predicting the relative success of
the divisions.
Pairs trading may also involve trading two companies in the same in-
dustry. Differences in product mix, financial leverage, and other factors af-
fect how closely two stocks track one another. The challenge with pairs
trading of separate companies is distinguishing short-term aberrations
from differences in performance that are sustainable due to differences
with the companies.
Pairs traders can cross check the performance of a pair of stocks using
a variety of statistical methods. Taken one step further, the statistical
analysis can identify candidate pairs based solely on the past performance
of the share prices. By opening up the makeup of pairs to statistically simi-
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