How investors can use the arbitrage opportunity to potentially make big returns

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This deal paved the way for Kubota to become the majority stakeholder in Escorts.

Kubota is the Japanese agri-machinery and construction equipment major, which already owns around 16.7% stake in Escorts as of February 2022.

The Japanese firm is expected to increase its holding to 53.5% through this open offer.

An open offer is an offer made by the acquirer to the shareholders of the company, asking them to tender their shares at a particular price.

This open offer was supposed to close in January this year, but Kubota revised the opening and closing dates. Under the revised schedule, the date of commencement of the open offer was 14 March 2022 and the closure date was 28 March 2022.

The last date to communicate the rejection or acceptance or refund of equity shares to shareholders is 20 April 2022.

While investors wait to see if their shares are accepted or not, this open offer has presented an arbitrage opportunity. One could potentially benefit from this opportunity and earn up to 80,000.

Sounds interesting, right?

Read on to find out how…

How Investors Can Potentially Make High Returns

At the onset, let us be clear. Things could go awry when you try to implement this strategy. So please prepare to stick it out if things don’t go your way.

For starters, let’s understand what arbitrage really is.

According to Investopedia, arbitrage is the simultaneous purchase and sale of the same asset in different markets to profit from tiny differences in the asset’s listed price.

Here, stocks (or commodities or currency) are purchased in one market at a given price and simultaneously sold in another market at a higher price.

This situation creates an opportunity for a risk-free profit.

The open offer by Escorts is presenting this opportunity at present.

The Escorts share price is currently trading at 1,638 per share.

In the future and options (F&O) segment, the March futures for Escorts are trading at 1,627 (1% discount to current market price).

Meanwhile, Escorts’ April futures are trading at a huge discount of 142, at 1,495.9 per share.

We don’t know why this has happened. It’s a mystery that the futures price for next month is available at such a huge discount to cash price. Normally, the futures should trade at a premium.

Does the market know something about Escorts that retail investors don’t?

While we don’t have the answer to this, the huge gap in prices has presented a good opportunity for arbitrage.

Investors having 550 shares of Escorts (the lot size of Escorts in the futures segment is 550) can use this opportunity and sell their shares and buy the April futures.

The difference between the cash segment and futures price will be your profit.

So, if you sell 550 shares of Escorts at a price of 1,638 and buy April Futures at a price of 1,496, the difference of 142 multiplied by 550 will be your profit.

That’s more than 75,000.

It seems as if people are coming to know about this opportunity and Mr. Market is already factoring this.

Yesterday, the April futures were trading at 1,474 and today they are up around 2% even as Escorts’ share dips in the cash segment.

It’s important to mention here that in the April futures, the cash price will converge to the futures price.

What this means is that as investors continue to use this arbitrage opportunity, the futures price and the cash price will slowly converge until they are equal, or close to equal.

Irrespective of whether the future is at a premium or a discount, on the expiry day, the futures and cash price will always converge.

About the open offer

Kindly note that if you have tendered shares in the offer, they will be accepted on a proportionate basis, subject to acquisition of a maximum of 37.5 m equity shares. There’s no assurance that all your shares will be accepted.

Escorts has announced that the open offer saw investors tendering 51.9 m shares against the offer size of 37.5 m shares. This implies an acceptance ratio of 72%.

Experts had suggested that shares of Escorts will fall today and that’s precisely what happened. But why did they fall?

The stock was expected to correct at least to those levels where the futures contract had closed yesterday.

Also, when the news of open offer came out in November last year, analysts were of divided opinions. They talked about the arbitrage opportunity but also said not to subscribe to the open offer.

While some said investors can buy and tender their shares if the discount between market price and open offer price remains attractive during the open offer period, many advised against it. They said the takeover will improve the company’s outlook. So it made sense to stay invested.

Final thoughts

Shares of Escorts bucked the trend and fell even as market climbed. Today, Escorts extended losses and fell 3% to close at 1,638.

It seems smart investors are selling their shares and hoping to make some potential bucks from this arbitrage opportunity. In the past three days, the stock has lost around 9%, falling from 1,802 last Friday to 1,638 at present.

The stock has already corrected significantly in the past few days creating a favourable risk-reward opportunity.

Even if investors don’t want to participate in this short opportunity, they could potentially gain from the rise in share price on strong fundamentals of a company.

Escorts has increased revenues and profitability over the years. It has also reduced its debt to almost zero and exited from the loss-making automotive component business.

Once the merger is done, and the transaction is complete, Kubota Agricultural Machinery India and Escorts Kubota India will be merged with Escorts. This could increase the company’s market share, manufacturing capacities, and distribution reach.

Disclaimer: This article is for information purposes only. It is not a stock recommendation and should not be treated as such.

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This article is syndicated from Equitymaster.com

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