Special Situation: IVRCL and IVRCL A&H

I wrote up on the special situation on my blog here -http://kiraninvestsandlearns.wordpress.com/2012/01/30/special-situation-arbitrage-between-ivrcl-and-ivrcl-ah/

The same has been pasted here for Valuepickr members comments.

Views invited.

Read upthis announcementby the IVRCL family. Thisannouncementon the BSE, regarding the decision from the CCI is almost like a final approval before the deal goes through. There is a High Court order that needs to be given yet to make this official, but this looks like a formality (but there is a timeline risk a I cover that below).

Quick calculations. 6 shares of IVRCL A&H at todayas market price of Rs. 35 will cost Rs 210. 5 shares of IVRCL at todayas price of Rs. 46.45 will cost Rs. 232.25. So, net arbitrage profit percentage in this deal is 22.25/210 = 10.59%. The deal is expected to be completed in the next 1-2 months. Annualized would be around 60-70%. Great deal, eh?

Not so soon. Letas just say we buy IVRCL A&H at Rs.35/- today. By the time the conversion happens, if the market turns and if IVRCL quotes at Rs.35 or below (look at the last 1 year stock price history), we make a loss. Our goal is to make market-neutral returns.

How do we ensure that there is risk-free arbitrage? Well, through IVRCL futures. We can buy shares of IVRCL A&H today and sell February/March IVRCL futures thereby ensuring market-neutral returns of 10.59% in 2 months.

Great. What is the catch? Well, there is no catch if you have lots of cash. Else, there is a catch. Futures get bought and sold in lots. One lot of IVRCL is 8000 stocks. That is, we can buy and sell IVRCL only in multiples of 8000 shares. Another complexity is in terms of margin. Since NSE has determined that IVRCL is volatile, the margin for buying/selling one lot of IVRCL is 30%. I illustrate the values in the figure below:


If we have to sell one lot (8000 shares) of IVRCL, we need to put up a margin of 30%800046.45 = Rs. 1,11,480.

The number of shares that we need to buy of IVRCL A&H to satisfy the sell of one lot of IVRCL futures is 80006/5 = 9600 shares. This would cost us Rs. 359600 = Rs. 3,36,000.

Therefore to play this risk-free arbitrage opportunity, we need to put up a cash of Rs. 336000+Rs.111480 = Rs.447480/-.

The return calculations are rudimentary and the figure below illustrates that:

(Rs.22.25*1600 = Rs.35600)

Moral of the story: If you have idle cash of close to 4.5 lakhs, there is a risk free opportunity for the taking.

My moral of the story: I donat have so much cash right now:))

Anyway, there are certain risks that we have to be aware of before we execute the trade:

a) There is a minute risk (very minimal actually, but scaring you nevertheless) that IVRCL might be taken off the futures list. If that happens, second leg of shorting the future has been eliminated and you would be exposed to pure stock risk.

b) The real risk is timeline risk. There is a high court approval that is yet to come and given our legal system, that might take time. In India, only the immediate next month futures are liquid. That is to say, if I were to execute this trade now, the most liquid futures would be the February futures. If the high court approval doesnat come through, I will have to roll over this short futures position over to March, which will involve certain transaction costs (the way I understand this rollover is a you buy back the Feb futures, sell the March futures) and hence might eat into the returns. If it doesnat come through by March, then roll over to April and so on and so forth, eating into the returns stated.

There would also be impact cost as you might not be able to buy at the same price.Sudden volume spurt would push up the price of IVRCL A&H and removeor reducethe arbitrage opportunity.

Good analysis Kiran. I just checked and the price of IVRCL A&H is now 40 and volumes are 4 times last 2 weeks. Sure some have realised the opportunity and jumped.When analysing such situations would a concept of margin of safety also help as is done for value based investing?

Buying 9600 shares say in 4 buckets of 2200 shares in the last one month would not have moved the stock by much. So you can safely ignore the impact cost in this instance.

Well, I became more confident of this opportunity after the go-ahead by CCI rather than before since that would be like betting on indefinite timeline. Some folks obviously are way more tuned in to the market and hence probably have exploited the opportunity already :slight_smile:

This is more of risk arbitrage where you buy a stock and sell a future and you knock both them off either side of the equation, pocketing the difference. Not too sure how you would bring in margin of safety here, in terms of numbers. We are not trying to predict the future, we are just exploiting the arbitrage opportunity. The only margin of safety angle I see in this is to get a grip on the timeline risk - which as I stated, I tried to value this only after approval from CCI.

Of course, if high court squashes this (unlikely, but even then, expected value is positive indicating the bet should still be taken), then you might not find the investment satisfactory.