TRACKING STOCK

Best defined with an example. Suppose Company 'A' purchases a business from Company 'B' and pays 'B' with 1 million shares of 'A's stock. In the agreement, there is a provision that 'B' cannot sell the 1 million shares for 60-days. In addition, the agreement prohibits 'B' from hedging by purchasing put options on 'A's shares or short-selling 'A's shares. 'B' is worried that the market may fall in the next 60 days. 'B' could hedge by purchasing put options or selling the futures on the SP 500. However, it is possible that 'A's business is much more cyclical that the SP 500. One solution to this problem is to find a tracking stock. This is a stock that has high correlation with 'A' let us call it Company 'C'. The solution is the sell short or buying protective put options on this tracking stock 'C'. This protects 'B' from fluctuations in the price of 'A's stock over the next 60 days. However, the degree of the protection is related to the correlation of 'A' and 'C's stock. It is extremely unlikely that the protection is perfect. Tracking stock is also used for internal evaluation. A firm with four divisions, for example, might set up four tracking stocks. The value-weighted sum of the four stocks exactly equals the firm's stock price observed in the market. This is a way to reward managers for good divisional performance with an equity that is tied to their division - rather than potentially penalizing their compensation for bad performance in a division they have no control over.