Look, how smart investors are making money on futures-spot mispricing

Mumbai: High net worth individuals (HNIs), ultra-HNIs and even informed retail investors have lapped up trades that offer annualised returns of between 15 per cent and 54 per cent by buying futures contracts and simultaneously selling underlying shares of Kotak Mahindra Bank, MRF, Bajaj Finance and Shriram Transport Finance Company that have seen heavy cash-based buying recently due to MSCI inflows running into billions of dollars.Termed reverse arbitrage, the trades exploit spot-futures mispricing due to supply-demand factors like the recent MSCI rebalancing-induced heavy cash buying, or corporate actions that lead to heavy futures selling due to anticipated fall in cash market shares. The trades in the current context offer risk-free monthly spreads or returns of 1.2-3.6 per cent. On an annualised basis, the returns gross 15-16 per cent and 54 per cent in one case. Kotak Mahindra Bank December 31 futures last traded at a Rs 23.3 a share discount (1.24 per cent monthly spread) to the spot price of Rs 1885.3, MRF futures were at a 2.11 per cent discount, Shriram Transport Finance (3.64 per cent) and Bajaj Finance (1.28 per cent). While Kotak Bank and MRF were inclusions into the MSCI India Index, Bajaj Finance and Shriram Transport Finance attracted buying on anticipated weightage increase.The constituents entering into such trades either own significant quantities of the underlying shares or have access to the exchange's stock lending and borrowing (SLB) platform. On the SLB, she can borrow the share for a fee from a counterparty, besides placing a 125-150 per cent cash margin against the borrowed shares.“The MSCI rebalancing has opened a reverse arb (arbitrage) opportunity, which is being exploited by arbitrageurs and other informed participants," said Rajesh Baheti, MD, Crosseas Capital.Normally, equity futures trade at a premium to the underlying spot price — called cash and carry arbitrage. That is because the futures price equals spot price plus cost of carry, which is nothing but the interest rate to fund the purchase of shares minus dividend earned.In the event of higher demand for cash shares relative to futures or heavy selling of futures due to anticipated fall in cash price, the carrying cost turns negative, opening an opportunity to buy the futures and sell cash shares.As spot and futures prices converge at or near expiry of a derivatives series, the trader pockets the pricing differential. At this stage the trade is reversed -- futures are sold and cash is bought back.“This is an event-based trade that aims to exploit mispricing between futures and spot for handsome, risk-free returns," said Chandan Taparia, analyst, Motilal Oswal Financial Services.“It's a no-brainer trade for those in the know," added Rajesh Palviya, derivatives head, Axis Securities.Such has been the buying frenzy in cash shares that Kotak Bank in the past seven sessions through November 27 saw delivery to traded volumes of 52-65 per cent against the three-month daily average delivery volume of 47 per cent. For MRF, delivery volume on November 27 alone was 67 per cent against the three-month daily average of 33 per cent. In Bajaj Finance, the past five days saw delivery to traded percentage at 19-56 per cent against the three-month average of 16 per cent. For Shriram Transport, Friday itself saw delivery volume of 60 per cent against the three-month daily average of 19 per cent.“Kotak Mahindra Bank and Bajaj Finance were the active MSCI names," said Abhilash Pagaria, senior manager, Edelweiss Alternative Research. "On SLB, proprietary desks borrowed and sold stocks to take advantage of the reverse arb opportunity."Brokers expect much of the MSCI related buying to have concluded by Friday as the global index management company announced on November 10, the rebalancing of the indices.

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