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Tracking stock

Definition: [crh] 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. The agreement provides that B cannot sell the 1 million shares for 60 days, and also prohibits B from hedging by purchasing Definition: 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 Definition: put options or selling the futures on the S&P 500. However, it is possible that A's business is much more cyclical than the S&P 500. One solution to this problem isDefinition: to find a tracking stock. This is a stock that has high correlation with A. Let us call it Company C. The solution is to sell short or buy Definition: HREF="/?rd=protective put+options">protective put options on this tracking stock C. This protects B from fluctuations in the price of A's stock over the next 60 dDefinition: ays. Because 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 Definition: 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 Definition: HREF="/?rd=firm's">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 divisDefinition: ion-rather than potentially penalizing them compensation for bad performance in a division they have no control over.

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