Parent company puzzle in Japan : another case of the limits of arbitrage

During the internet bubble in the U.S., there were several instances that the market value of a parent firm was less than the market value of its holdings of a publicly traded subsidiary. This parent company puzzle is also observed in Japan. The objective of this paper is to investigate whether this puzzle represents mispricing by the stock market, and, if so, to investigate why the observed mispricing persisted for a long period of time. The results are inconsistent with market efficiency. Because of market frictions, there is no guarantee that distortions in stock prices will always be quickly corrected by arbitrage transactions. Surprisingly, even highly liquid stocks listed on the First Section of the Tokyo Stock Exchange (TSE) can deviate substantially from fundamental values for a long period of time. We suggest these large and persistent price distortions could be attributable to the lack of active arbitrage activity in Japan due to market frictions.