Monday, May 26, 2008

Buying R-Power Rs 400 June puts

I am trying to figure out futures and options. So today, I did the second option trade of my life. I bought some R-Power put options.

The IPO of R-Power in Jan 08 was a seminal event in the history of Indian markets - it called the top of the Indian stock market euphoria. But while Indian markets have fallen from 21K to around 16K since then, R-Power is sitting close to its IPO price of Rs 450. Why?

To figure this out, lets recollect the series of events around R-Power.

Early Jan 2008: Anil Ambani is able to con people to give his paper company a $25bn valuation.
IPO price = Rs 450.
Public shares outstanding = 228 million.
Public shareholding =10.09%. Rel Energy (now Infra) holds 45%, Ambani junior holds another 45%.
Total shares outstanding = 2.259 billion.

Early Feb 2008: R-Power lists and tanks.

Late Feb 2008: Anil Ambani comes out with a 3:5 bonus offer for all public shareholders. That is, the company will issue 136.77 million more shares but only to the public shareholders. This will bring up public shareholding to 15% in R-Power. Anil Ambani also transfers some of his shares to Rel Infra, so that Infra's stake in Power remains 45%, while his stake in Power falls to 40%

June 2, 2008: record date to determine eligibility of shareholders to receive bonus shares.

This is a very unique bonus issue. It is being offered to only one set of shareholders and not to others. So, it is a transfer of wealth from one shareholder to another. There are two possible adjustment factors - 62.5% (=5/8) and 94% (1 - 6%) for the stock post the dilution event, which has created confusion and opportunity.

Let us buy 5 shares of R-Power stock today at price x. We will get 3 additional shares and will have 8 shares of the same company in a few days. If the price at that time doesn't fall below 5/8*x (=62.5% x), we would have made an arbitrage profit. And why should it fall below 5/8x? After-all, the company is issuing only 6% more shares (136.77 million additional shares divided by 2.259 billion shares shares outstanding earlier). So the price should fall by only 6%, and should be 94% of the price pre-dilution. If that is how it works out, we will make 50% profit (8 shares * 0.94 *x - 5 shares * x)/5x = 50%

Note that x is immaterial. By this logic, we should be willing to buy RPower at any price - 350, 400, 450, 4500. Clearly, that is wrong.

I think this is the logic that has kept RPower stong over the last couple of months. Even today, it is a $25 billion company without any real business, except the $2.5 billion raised in IPO. It has outperformed Sensex and it has outperformed other ADAG companies like RCap, which have similar fluff.

Once June 2 comes and goes, I think investors are going to start selling massively. They won't receive the bonus shares for a few more days, but they can definitely sell whatever they have to lock in part of the profits.

With options, there is the trickiness of the adjustment factor. What does the exercise price adjust to post issuance of bonus shares? Does it adjust to 94% (1-136.77/2259) of the strike price, or does it adjust to 62.5%? I think it will be 94% - (the exchanges have yet to come out with the clarification). The stock should, however, adjust much more - ideally, it should fall to 62.5% of the pre-dilution price - otherwise there is free money for public shareholders.

So, the Rs 400 put option will adjust to a Rs 376 put option. I am betting that R-Power is going to fall far below this level once the record date for bonus issue is out of the way. 62.5% of Rs 450 is Rs 281, and that is where the stock should go. Even then it will be a $17 billion company. Contrast that with Tata Power - $8 billion market cap, with an ownership stake of 30% in Bumi Resources, which is worth $6bn at today's prices.

Of course, I could be wrong. Exchanges could decide the adjustment factor is 62.5%, and markets can decide the adjustment factor is 94% - this is after all a Reliance stock.

The premium for the Rs 400 June put option was Rs 4. My downside for 1 lot of 450 is Rs 1800 while upside can be huge. So that is why I did this trade. Lets see how it works out.

I was also thinking - can one make arbitrage profit today by using futures? That is, I buy 5 shares of RPower, and sell 8 shares in the future markets. Suppose futures adjust to 94% post issuance of bonus shares. I would have made risk-free profit. Unless futures adjust to 5/8x, I will make profit at any x. Maybe this is also what has been pushing R-Power price up. I dont know how futures adjust for issuances of bonus shares, so this is going to an excellent learning experience.


prabhat said...

Good analysis , lets see how it work out.

Prabhat Mishra
Private Banker

Anonymous said...

highly stupid analysis....the author doesnt know anything about fut/options. this is evident from the analysis he has published. dont ever try to follow his recommendations.


Great article