Friday, November 12, 2010

Dealing with FPOs

There is a spate of follow-on public offerings in the offing - Power Grid is already behind us, SAIL, ONGC and some other PSUs are to follow. FPOs are an interesting animal. Unlike IPOs, FPOs already have a traded security in the market. The price discovery hence is already done. Unlike the IPO the issue price can be benchmarked to something real. For investors this is a good indicator of whether they should buy in the follow on issue or simply from the secondary markets - something dependent on the degree of the discount offered in the issue.

Since the issuer would want investors to subscribe to the issue despite the availability of the same shares in the secondary markets, it is understandable that FPOs would typically happen at a discount to the prevailing market price. While this is a small positive for the long term investor, it is potentially a very interesting opportunity for the short term investor. Inherent to the discount is an arbitrage opportunity. Since the FPO is likely to be in discount to the open market price, one can short the futures of the underlying security in the secondary markets and bid for the issue. When the allocation happens, one can square off the futures position as well as sell the alloted shares. This would lock in the price differential. Of course one needs to estimate the allocation amount. Given this, one can even use leverage to further boost the returns - especially since this strategy is relatively free of market risk.

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