Primes and Scores: An Essay on Market Imperfections




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    • S. C. Johnson Graduate School of Management, Cornell University. We would like to thank Robin Brenner for computer assistance and David Easley, B. Jesper Christensen, James MacBeth, Dale Morse, René Stulz, Robert Whaley, an anonymous referee, and seminar participants at Cornell, Michigan, Ohio State, and the Western Finance Meetings (June 1988) for helpful comments. Financial support from the Mobil Oil Foundation is gratefully acknowledged.


This paper investigates the reported relative mispricing of primes and scores to the underlying stock. Given transaction costs, we establish arbitrage-based bounds on prime and score prices. We then develop a new nonparametric statistical technique to test whether prime and score prices violate these bounds. We find that prime and score prices do exceed stock prices, and often by a considerable amount. We demonstrate that this increased value is most likely due to the score's ability to save on the costs of dynamic hedging. We also show how short sale and trust size constraints impede the ability to arbitrage price disparities.