12) Arbitrage your free lunch

There is opportunity in market mis-pricing of stocks

Aditya who holds a portfolio of stocks, saw a news item on the front page of a financial daily, which said that Hell is to be merged with Heaven, with every shareholder in Hell getting a share in Heaven (namely, a stock swap ratio of 1:1). He immediately turned to the stocks page and found that while Hell was trading at Rs 80, Heaven closed on that trading day at Rs 100, leaving a Rs 20 price gap between the two stocks.

Aditya wondered if he had spotted an opportunity to lock into a riskless profit or what in stock market parlance is called arbitrage. He decided to dig deeper by browsing the Net and what he found left him intrigued.
Just as day trading fascinates hordes of people, there is a separate set of professionals who make a living by spotting arbitrage opportunities.

Mind you, in the developed world, there are special funds that make money only by looking for these mis-pricing opportunities. Arbitrage, also known as risk less profit and, more popularly, as free lunch, is the simultaneous purchase and sale of assets to make a profit from the difference in pricing.

Aditya, in this hypothetical illustration, could have acquired shares in Hell and sold Heaven in the futures market. (Futures market is one where agreement over price and quantity of an asset is reached for transactions that are to be undertaken at a specified future date.)

This transaction, stemming from a merger or acquisition, is called risk arbitrage. It involves short-selling the stock of the acquiring company and going long (buying) on the target company. Short sales is the act of selling a stock without actually owning it.

In an efficient market, however, it is almost rare to spot such opportunities. The Indian stock markets, however, have thrown up some such opportunities in the recent past. Making a straight-forward profit, however, in such transactions may not be easy, since only a small list of securities can be traded in the derivatives market. With only about 110 securities available in the single stock futures list, traders in most cases would have to resort to the cumbersome set of day-trading transactions to put through this strategy. But before you lose heart, read on to see if one can work around these limitations.

Strategy 1

Traders could profit from adopting a modified strategy of buying the stock of the target company and selling it just before the delisting date or after the shares of the acquiring company are allotted.
You, however, need to take a call on whether the prices of the acquiring company will remain flat or move up. For instance, take the case of the merger of Williamson Tea Assam with McLeod Russel earlier this year.
In early July, when Williamson Tea Assam was de-listed, McLeod Russel traded at about Rs 100 and Williamson at Rs 280. Based on the stock swap ratio of three shares of McLeod for every one of Williamson, the latter should have traded at a readjusted price of about Rs 300.
Investors using the arbitrage concept could have pocketed a 4 per cent profit by taking an exposure in Williamson on July 13 (the last trading day) and exiting the McLeod stock on August 3, about a week after fresh shares of the McLeod were issued.

Traders could have also pocketed similar gains had they taken up exposures in the stock of Vanavil Dyes trading at about Rs 60 on April 12 and exited the Clariant Chemicals stock in early May when it was quoting at about Rs 360.

The ratio for this merger was one share of Clariant for every five of Vanavil. This was another instance of a merger offer of Vanavil Dyes with Clariant Chemicals.

Caution
However, this strategy is not without its share of risks. For instance, consider the merger of FCGL Industries with Gujarat NRE Coke.

In December 2005, when the swap ratio was fixed at 1:1, FCGL Industries traded at Rs 80, while Gujarat NRE Coke quoted at Rs 100. The traders who attempted to capitalise on this 25 per cent price gap might have been caught on the wrong foot. In late May, when the FCGL
Industries stock progressed towards the delisting day, the price gap between FCGL and Gujarat NRE Coke narrowed to 10 per cent leaving very little arbitrage opportunity.

STRATEGY 2

Traders may, however, stick to the risk arbitrage strategy for stocks that are listed in the futures space. They could have made commendable gains by adopting this strategy in the merger of Vashisti Detergents with Hindustan Lever (HLL) by simultaneously acquiring the stock of Vashisti Detergents in February and shorting the HLL stock in the futures market, one could have profited by as much as 7 per cent within a span of two months when fresh shares of HLL were allotted. This strategy carries negligible risk, as irrespective of the stock price movement, gains are almost assured. How? Because if the trader loses money in the futures market on account of the rise in HLL's value, he would be making money on the purchase of Vashisti as he would be getting higher value shares of HLL after the merger.

However, this strategy also carries a risk. If the merger is called off or there is a long delay in it going through, it could result in an unattractive payoff to shareholders.

As the late Milton Friedman was fond of saying, ``there is no such thing as a free lunch in this world''. But if you are a savvy investor willing to take a fair share of risks, spotting arbitrage may be just that exception to the general rule.