Tests of the Efficiency of the U.S. Rights Offering Market: An Option Pricing Approach.

The efficiency of the U.S. market for stock purchase rights is empirically analyzed in an option framework, in which prices of rights, given the prices of underlying stock, are examined with regard to the possibilities of actually earning above-normal profits, considering the risk taken. Two neutral tests for market efficiency, along with a simple buy-and-exercise trading strategy, are applied to daily trade rights data. Results from ex-post hedging tests suggest that the trading strategy based on the rights valuation model is able to differentiate between overpriced and underpriced rights so as to generate substantial book profits. The positive ex-ante hedge return, found to exist empirically, is completely eliminated once transaction costs are introduced, lending support for the efficient U.S. rights offering market on an after-transaction cost basis. Copyright 1996 by Kluwer Academic Publishers