No arb in Karnataka Bank

There’s a little bit of confusion going around because Economic Times had published this article: (You can make upto 66% by participating in Karnataka Bank rights issue).

They mention that you could buy 4000 Karnataka Bank shares and short 6000 or the futures appropriately but also buy the remaining shares at 50% lower in the 2:1 rights issue announced recently. That would give you a fancy arbitrage.

This arbitrage doesn’t exist.

Because when such rights issues happen, two things change.

  1. NSE adjusts the futures price downwards. So if you sold at 140, your selling price will be adjusted down so that it comes to Rs. 116. (Calculations later)
  2. NSE increases the lot size appropriately. The 6000 lot would go to around 7200 shares per lot.

Effectively, if you shorted 6000 futures of KTKBANK at 140, you would, post the record date, have a short of 7200 shares at 116 each.

The Calculations

Assume you have 2 shares of Karnataka Bank. You get 1 at Rs. 70 in the rights issue. NSE has an adjustment factor for the downward adjustment of the future price and upward adjustment of the lot size. See here for a recent example with GMRINFRA.

So if the price is Rs. 140, that means you invested Rs. 280 for two shares. You get one more share at Rs. 70. So you have invested Rs. 350 for three shares. That is Rs. 116.67 per share.

Therefore the price should fall to Rs. 116.67 per share. From Rs. 140. That’s a downward adjustment of 0.83333 on the futures price (adjusted 83% lower) and the lot size will be increased to 6000/0.8333 = 7200.

No arb in Karnataka Bank So in effect you don’t make any money in this “arbitrage”.

Just clearing out the confusion, since a lot of twitter traffic has erupted on this note.

Now, tell them about it: