ARBITRAGE PROCESS

By Parikshit Nandwana

The term arbitrage refers to an act of buying an asset/security in one market (at lower prices) and selling it in another (at higher prices).

ARBITRAGE In economics, arbitrage is the practice of taking advantage of a state of imbalance between two (or possibly more) markets: a combination of matching deals are struck that exploit the imbalance. B2B Definition: Arbitrage A method of taking advantage of the fact that there may be different prices in different markets for identical goods such as gold, foreign exchange or commodities. ARBITRAGE " A technique employed to take advantage of differences in price. If for example, ABC stock can be bought in New York for $10 a share and sold in London at $10.

The behavior of the investors will have the effect of;

(i) increasing the share prices (value) of the firm whose shares are being purchased; and (ii) lowering the share prices (value) of the firm whose shares are being sold.

Problem Assume there are 2 firms L and U which are identical in all respects except that firm L and has 10% Rs 500000 debentures. The earnings before interest and taxes (EBIT) of both the firms are equal that is Rs 100000. the equity capitalization rate (ke) of firm L is higher (16%) than that of firm (12.5%)

Total Value of firms L and U

Total Value Of Firm L and U L EBIT Less: Interest Income to Equity Holders Equity Capitalization Rate (ke ) Market Value Of Equity (S) Market Value Of Debt (B) Total Market Value (V) Implied overall capitalisation rate/cost of capital (K0)= EBIT/V Debt equity ratio = B/S 100000 50000 50000 0.16 312500 500000 812500 0.123 1.6 U 100000 NIL 100000 0.125 800000 NIL 800000 0.125 0.

Effect of Arbitrage (A) Mr. Xs position in firm L (levered) with 10% equity holding (i)Investment outlay (ii)Dividend Income (B) Mr. Xs position in firm U (unlevered) with 10% equity holding (i)Total funds available ( own funds Rs 31250 + borrowed funds Rs 50000) (ii)Investment outlay( own funds Rs 30000 + borrowed funds Rs 50000) (iii) Dividend income: Total Income (0.10 Rs 100000) Rs 10000 Less interest payable on borrowed funds Rs 5000 ( C ) Mr. Xs position in firm U if he invests total funds available (i)Investments costs (ii)Total income (iii)Dividend income (net) (Rs 10156.25 Rs 5000)

31250 5000

81250

80000

5000

81250 10156.25 5156.25

Arbitrage Process: Reverse direction According to the MM hypothesis since debt financing has no advantage it has no disadvantage either. In other words just as the total value of a levered firm cannot be more than that of an unlevered firm cannot be greater than the value of a levered firm. This is because the arbitrage process will set in and depress the value of the unlevered firm and increase the market price and thereby the total value of the levered firm. The arbitrage would thus operate in the opposite direction. Here the investors will dispose of their holdings in the unlevered firm and obtain the same return by acquiring proportionate share in the equity capital and the debt of the levered firm at a lower outlay without any increase in the risk.

Problem : Assume that in previous example the equity-capitalization rate (ke) is 20% in the case of the levered firm (L) instead of assumed 16%.

Total Value Of Firm L and U L EBIT Less: Interest Income to Equity Holders Equity Capitalization Rate (ke ) Market Value Of Equity Market Value Of Debt Total Value (V) (Ko ) B/S 100000 50000 50000 0.2 250000 500000 750000 0.133 2 U 100000 NIL 100000 0.125 800000 NIL 800000 0.125 0.

Since both firms are similar except for financing-mix a situation in which their total values are different cannot continue as arbitrage will drive the two values together.

Suppose Mr Y has 10% shareholdings of firm U. He earns Rs. 10000 (0.10 Rs. 100000). He will sell his securities in firm U and invest in the undervalued levered firm L. He can purchase 10% of firm Ls debt at a cost of Rs. 50000 which will provide Rs. 5000 interest and 10% of Ls equity at a cost of Rs. 25000 with an expected dividend of Rs. 5000 (0.10 Rs. 50000). The purchase of a 10% claim against the levered firms income costs Mr Y only Rs. 75000 yielding the same expected income of Rs. 10000 from the equity shares of the unlevered firm.

Effect of Reverse Arbitrage Process (A) Mr Ys current position in firm U Investment outlay Dividend income (B) Mr Y sells his holdings in firm U and purchase 10% of the Levered firms equity and debentures Debt Equity Total Y would prefer alternative B to A as he able to earn the same income with a smaller outlay. (C) He invests the entire sum of Rs. 80000 in Firm L Debt Equity Total He augments his income by Rs. 666.70. Investment Rs. 50000 25000 75000

Rs. 80000 10000 Income Rs. 5000 5000 10000

Investment Rs. 53333.00 26667.00 80000.00

Income Rs. 5333.30 5333.40 10666.70