Here's an idea for people looking for arbitrage opportunities in the Indian markets.. The pre-tax exptected returns are approximately 15-20% (annualized) compared to 10.5% pre-tax in a bank deposit.
The idea's a variant of convertible arbitrage where we can exploit the difference between equity shares (EQ) and convertible stock (CCPS) of Tata Steel (details of converion can be found here). Briefly, under the terms of conversion, 6 CCPS shares will automatically convert to 1 ordinary EQ share on 1st Sept 2009.
CCPS paid Rs. 12 (Rs. 2 per CCPS * 6) dividend while the ordinary stock paid a dividend of Rs. 16. Dividends on both the equity stock and CCPS have been paid for 2008 and if one assumes the same dividend for 2009 (though dividend on the EQ share may be cut given the financial pressure on the company), it accounts for a discount of Rs. 0.66 per CCPS. If one discounts the cash flow, the figure is even lower.
The EQ share has been trading at a premium of between 5% to 15% to the CCPS. For the month of October, it averaged at 11.5% (12.5% annualized).
To lock in this arbitrage profit, one should buy the CCPS in the cash market and short the futures in the derivative markets (since the stock borrowing is not feasbile in the Indian markets) and keep rolling the short positions on the futures till Sept 2009. In Sept 2009, on receipt of the EQ shares in lieu of the CCPS, the position is reversed to realize the profit.
As a matter of fact, since stock futures trade at a premium to the underlying EQ share, one will gain an additional 10-12% over the 11 month period under normal market conditions. Therefore the returns can be as high as 20% to 25% for the 11 month period untill Sept 2009.
Since we cannot practically short the EQ shares and have to reply on the futures, we run the risk of losing money on the trade if the stock futures trade at a discount to the underlying common stock (EQ) through the 11 month period (known as backwardation). This is possible in the Indian markets since futures are cash settled.