V Pattabhi Ram and A V Vedpuriswar
Goggles (because he always wore goggles outside the classroom) hadn’t been quite impressed by the professor’s arbitrage theory discussed last week. He had dug into the website for answers but it had only thrown up more questions. He had made up his mind to aggressively quiz Professor Chatshow; the latter’s great reputation not withstanding.
His research had led to some startling findings. Like, the US mutual fund industry offers country funds. This is money raised in USA for investment in foreign countries. Thus if the money is to be invested in Japan it is called Japan fund. Back in 1987, the Taiwan Fund, trading on the New York Stock Exchange (NYSE), quoted at a price that was thrice its NAV. Most interestingly, the premium stayed above 100% for 10 weeks, and above 50% for another 30 weeks.
“Sir, isn’t that stupid?” Goggles asked Chatshow. “Why would a US investor be willing to pay a dollar to buy less than 33 cents worth of assets?” Before the professor could respond, the girl in the middle row (GITMR) cracked, “Hey, forget 1987, we were in kindergarten then.” The professor ignored her wise crack and remarked, “What could the Americans have done? To gain from arbitrage, they could have directly invested in the Taiwan market instead of investing through the fund. But the law forbade U.S. investors from doing so. That explains the discount”.
“It doesn’t” screamed Flowers. All eyes turned towards him. While intellectual irreverence was accepted at the b-school, raising the decibel level, that too condescendingly, wasn’t. “Sorry,” said Flowers. “It may explain why the arbitrage is panning out but it does not explain why people are paying for an asset three times its value.”
Boka rose in Flowers’ defence. “Last night I browsed the net. In 1989, when the Berlin wall fell, German stocks shot up. By Jan 1990, the Germany fund was quoting at a 100% premium on the NYSE. This anomaly did not seem to make sense since U.S. investors were free to invest directly in Germany.” Debbie, the lollypop faced class topper, responded: “Maybe, the American investors were too scared to invest directly in the German market and hence their desire to go through the fund route. And they were willing to pay the extra price”. There were a few appreciative nods. Boka wasn’t impressed. He said, “That’s right, but why pay a 100% premium?”
GITMR was tired with ancient stories. “Can we have some recent examples please?” she asked. A backbencher hissed “American Depository Receipts (ADR)”. An ADR is a share of a specific foreign security held in trust by U.S institutions. Claims to these shares trade on NYSE. These too quote at a price different from the value of the underlying assets. But there should not be significant deviations, since arbitrage is possible. He recounted, “On Feb 18, the Infosys ADR was trading at $72.8. Simultaneously, in India, it was available at Rs 2174. Given an exchange rate of Rs. 43.8 per dollar the ADR should have quoted $50 approx to eliminate arbitrage. That’s just one example. Almost every Indian ADR is quoting at a premium”. Debbie said, “Perhaps that’s why Indian companies are now planning to do a sponsored ADR”. Flowers explained, “In a sponsored ADR the Indian shareholder hands over his stock for converting it into ADRs and selling it in the US market. The Indian investor then pockets the price differential”.
Chatshow decided it was time for him to intervene. “Two things explain the price differentials. One, official barriers prevent Americans from buying the shares trading in Mumbai. Two, American investors might attach a premium to Infosys because its returns are negatively correlated with other assets held by Americans. So Infosys offers valuable diversification. Indian investors, on the other hand, might place a lower value on Infosys since it confers no diversification benefit on them”. Boka wondered, “But does it still justify such a huge spread?”
The question veered to why mutual funds should quote at a discount to NAV in native India. Flowers volunteered, “The gap between market price and NAV could be for many reasons. Like, the portfolio manager charges a fee for his services. So the cash flows going to the holders of the fund are different from those going to the holders of the underlying assets. Hence the discount. Even premiums could be rational if the fund manager had superior stock picking ability”. Boka wasn’t impressed. He asked aloud, “Do they call for such dramatic price gaps?”
Chatshow decided to get cracking. “A point which most people do not appreciate is that arbitrageurs may not play the game because violations of the law of one price do not necessarily create risk free arbitrage opportunities. They just create good but risky bets. After taking a position, the price differential may widen, not narrow. Traders may get excited (or depressed) about some security and create a major mispricing. In extreme cases, this widening spread can cause arbitrageurs to go insolvent”. One example is the celebrated hedge fund, Long-Term Capital Management (LTCM), which had several “convergence trades” in place during the summer of 1998. Most of their bets involved mispriced securities. When spreads widened in 1998, resulting in divergence rather than convergence, LTCM ran into trouble. It attempted to raise new money, but found no takers. Mark it, LTCM had to eventually close shop.” The class heard the professor in silence.
Boka decided to bring the issue to desi levels. “India violates the law of one price like no one else does,” he said. “Explain”, shot the professor. “When you take an auto from the city railway station, you are taken for a ride. Literally. Sir, it costs 50% more than what it would if you walked 200 meters from the station to pick a plying auto”. Flowers wondered aloud, “Why do we still take an auto from inside the station?” And volunteered a reason. “Because we are lazy.” “Nope”, said Goggles, “Because, the police ensure that no auto is seen in the vicinity! At least, that’s true of a few airports. That’s some law enforcement indeed”.
By now others were beginning to get a whiff of the stuff. “Nothing like day-to-day examples” hissed Debbie. “The price of a cup of coffee at the airport lobby is 50% lower than that in the security area” said the resident quizzer who had only the previous week flown to Delhi to successfully win the India Quiz on television. “Rs 20 in the security area, Rs 10 at the lobby. But that isn’t arbitrage,” said Debbie. “When you get into the security area, you cannot come out. Hence ‘coffee at the entrance’ is different from ‘coffee at the security area’. You therefore have no choice.” The class smiled. Only Debbie could have put it so profoundly. “You cannot play arbitrage. You cannot buy at Rs 10 from the vendor outside and sell it at Rs 12 to the vendor inside!” closed out GITMR. Chatshow was impressed. You don’t have to go to railway stations and airports to see the presence of arbitrage. “Prices of vegetables in the subzee mandi shoot 50-100% by the time they arrive in departmental stores in the city. Prices of fruits are 300% up when they move from the farmers to the customers. Research by NABARD reveals that in 2001, a rose cultivator got only 53% of the price, which the consumer paid in Calcutta” said the resident quizzer.
Chatshow was thrilled by the way the discussion had progressed. Here was the possibility of arbitrage play. Here was a bunch of young wannabe managers who had learnt why arbitrage might appear to exist but why you cannot profit from it.
|Company||18 Feb Rs
|18 Feb ($)
|What it should have been on 18th Feb in $|
|HDFC Bank||775.8||$ 43.75||$17.71|
|ICICI Bank||376.85||$ 22.00||$ 8.60|
|Satyam Computers||408.25||$ 25.17||$ 9.32|
|Dr Reddy||740.45||$ 17.78||$ 16.9|
|Infosys Technologies||2173.95||$ 72.80||$49.63|
|Wipro||697.40||$ 22.01||$ 15.92|
|MTNL||137.55||$ 7.01||$ 3.14|
Note: The dollar on Feb 18 2005 stood at Rs. 43.80