Nifty: The arbitrage anomaly

Historically low implied volatility hints the stockmarket is headed north

Nifty futures have traded at a discount for around two months in a row now. On Thursday, the near month (i.e. June) futures closed 26.6 points or about 1.3 per cent lower than the spot Nifty.

With 28 days to expiry, the annualised cost of carry works out to a rather high -16.6 per cent.

The discount has mostly been either in that range or higher in the past two months, which brings us to the obvious question, "Why aren't arbitrageurs taking advantage of this pricing anomaly?"

For one, the discount is not as high as it seems. Almost all companies that make up the Nifty have announced hefty dividends, and this income must be deducted while calculating the fair futures price.

The expected dividend income itself accounts for about 10-12 points of the discount, analysts estimate. On an annualised basis, therefore, the discount works out to about 8-10 per cent. But even then there's ample room for arbitrage.

The fact that the discount has persisted for a long period indicates that arbitrage may not be easy or very profitable. To take advantage of the discount, arbitrageurs would have to buy futures and sell the underlying "" in the Nifty's case, all the stocks that make up the Nifty.

With the stock borrowing mechanism not having taken off, borrowing related costs would be high. Besides, apart from transaction costs, arbitrageurs also have to deal with high margins.

The fact that their positions are largely risk neutral don't result in lower margins, which makes things worse.

As far as market direction goes, the discount on the futures probably points to expectations of a correction going ahead.

The implied volatility (worked backwards from option prices), meanwhile, is at historically low levels of about 8-9 per cent, indicating that market players aren't really worried about their positions in the market. A high level of complacency as this normally leads to a market peak.

Britannia

Biscuit-major Britannia's sales for the quarter ended March 2005 were just 5.5 per cent higher. This could partly be because of a high base last year's Q4, when sales had risen 15 per cent.

But it still reflects the tough competition in the biscuits segment. Worse still, operating profit fell sharply to Rs 29.2 crore, a drop of 15.6 per cent, as operating margin fell almost 200 basis points to 7.6 per cent.

Raw material costs as a percentage of sales were up at 56.12 from 53.9 per cent, since prices of its main inputs wheat flour and sugar having increased.

Besides, competitive pressures seems to have compelled the company to increase its spends on advertisement and promotion, which went up 34 per cent at Rs 26.9 crore.

Further, the company's other income was significantly lower at Rs 12.5 crore, and consequently the profit before tax and exceptionals dropped to Rs 36.6 crore, a fall of 37 per cent.

The numbers for the full year, however, are slightly better with sales increasing by 10.3 per cent and operating profit growing by 8 per cent to Rs 183.9 crore.

The operating profit margin dropped slightly to 11.6 per cent from 11.8 per cent. The pressure on margins indicates that the company has not been able to pass on the higher cost of raw materials.

A jump in other income thanks to sale of investments helped boost profit before tax and exceptionals to Rs 242 crore, a rise of 23 per cent. The stock, at Rs 867, trades at a trailing multiple of 14.3 times and a forward multiple of around 12.5 times.

Based on last year's operating profit growth of 8 per cent, the stock seems fully priced. Going forward, competitive pressures are expected to eat into Britannia's market share, while on the cost side the company could benefit from the upcoming facility at Uttaranchal.

Steel prices

Steel prices have been cut by up to Rs 2,000 per tonne by most players except Tata Steel. As anticipated, metal stocks faced selling pressures with BSE's metal index falling by 2.3 per cent in the past two days.

While the Street has reacted nervously, analysts at domestic brokerage houses have not yet downgraded profit forecasts for integrated steel companies.

For one, a correction in prices was expected. Besides, domestic steel demand is expected to grow at about 6-7 per cent in the medium term and partly make up for the lower prices.

In addition, export markets like Middle East are also projected to see demand growth of 6 per cent. However, the situation in China continues to remain uncertain.

A key concern for Indian players is that Chinese exports of steel and semi finished products jumped almost six fold in the first four months of this year.

While most steel companies have long term contracts with their OEM clients, the underlying fear is that retail demand could start increasingly shifting toward cheaper Chinese imports.

This segment typically constitutes about 25-30 per cent of the total customer base for a steel player.

On the cost side, integrated players like SAIL have captive resources of key inputs like iron ore. However, prices of other inputs like coke, which are mainly sourced overseas, have not shown signs of easing.

Steel companies have implemented productivity techniques to minimise the usage of coke. But analysts point out that operating margin would still be under pressure.

For smaller steel players, things could be even worse, as long term iron ore prices have also been recently hiked by about 71 per cent.

Yet, although investor sentiment has been hit in the short term because of the price cuts, steel stocks do not appear very expensive-SAIL trades at about four forward earnings, while for Tata Steel the forward PE is about five times.

With contributions from Mobis Philipose, Shobhana Subramanian and Amriteshwar Mathur.