Who says markets are efficient: Lots of free lunch in the market

Efficient market hypothesis states that markets are efficient. Market price reflects the true price of a share. There is no information asymmetry and there is no free lunch available for any investor in the market. But it is not true. You always find a free lunch in markets. Just need to understand and grab it.

Indian Govt. is continuously coming out with several IPOs and FPOs with a 5% discount for the retail investors. We have the free lunch in it being a retail investor.

FPOs: All the companies come out with an FPO at a discount compared to the current market price. Otherwise people would prefer buying from the market than from the FPO. So, to raise money, the company has to give discount on current market price. Govt. FPOs also give a discount of 5% for the retail investors. The best strategy to grab the free lunch is to buy an ATM put options that costs approx. 3-5% of the market price. Apply for an FPO that is priced at a discount of more than 5%. The minimum profit that we get at any cost is (Market price – FPO price – Put option premium – all transactions costs). If the price on the day of listing is more than the strike price of the FPO, you earn more and if it is less, you get your minimum profit.

Eg: Power grid FPO with price band of 85 to 90 and trading at 100 with ATM (strike = 100) put costing 3 to 5 rupees and 5% discount for retail investor. So, if we pay Rs.4 as premium for 100 – Put option, minimum profit for retail investor = 100 – (90-4.5) – 4 – transaction cost = approx. Rs.10/share (Free lunch in efficient market). If, on the day of listing, price is above 100, we have lot more than Rs.10/share. It is clearly an arbitrage opportunity.

IPOs: Govt. sells the shares at a discount than its valuation for an IPO so as to attract the investor for the IPO. Retailers also get a discount of 5% in the IPO. So, the obvious thing that can happen is to get a min. of 5% benefit in an IPO for an investor. The best example is the latest IPO by Coal India. But efficient market hypothesis may work here.