IDFC First Bank Limited

This is true. Although, it is not possible to short in cash market for overnight held positions. So, one has to short in F&O, which can be done for a maximum of three months at any point of time.

Any profit and loss in F&O is added to other income/ business income and is taxed at marginal rates. So if you are in 30% tax bracket you are going to pay 30% tax and not 15/10% capital gains like the cash market.

Having said that, what you said makes perfect sense, since there is a 15-16% arbitrage between the stock prices based on their current market price (CMP) and the merger ratio which is already decided and approved by the resepective boards.

For the uninitiated, this works like the following:
CMP of IDFC Limited is Rs 121 and CMP of IDFC First is Rs 91. For every 100 shares of IDFC, we’ll get 155 shares of IDFC First @ effective price of Rs 78-79 including brokerage, which is at a 14% discount to its CMP of Rs 91.

As the date of merger approaches this arbitrage will vanish eventually. This is the “special opportunity” some of us can take benefit from.

Of course one can buy IDFC (which I have done) but that does not guarantee a profit. Because when the arbitrage vanishes it may happen by significant erosion in IDFC First share price as well (rather than appreciation in shares of of IDFC Limited). Also there could be overall correction in the market which could result in both shares correcting, with lesser correction in IDFC compared to IDFC First. In this scenario, buying IDFC helps in limiting downside but does not guarantee a profit.

My reason of buying IDFC is not for pocketing the arbitrage. I have bought IDFC because I believe in IDFC First, and buying IDFC Limited gives a cheaper cost of acquisition for IDFC First. For pocketing the arbitrage, one has to execute the long-short strategy that you have mentioned.

In the F&O market, the lot size of IDFC is 10000 while IDFC First is 15000 shares. Therefore an exact ratio +100 IDFC and -155 IDFC First is not possible. One can do a +100 IDFC and -150 IDFC First which is good enough.

Suppose on Sep 1, one buys one lot of IDFC Ltd with expiry date of 30-Nov-2023. Simultaneously one has to sell one lot of IDFC First with the same expiry date of 30-Nov-2023. Around 30-Nov, one has to roll over to the furthest series again based on visibility of merger. I recommend buying furthest expiry to reduce transaction costs. One has to provide the required margin for this trade, otherwise there will be huge interest cost on the margin since this exposure will remain open for a long time.

As the arbitrage disappears this trade will become profitable. There are three/ four scenarios:

Both stocks appreciate, but IDFC Ltd appreciates more than IDFC First
Both stocks correct, but IDFC First corrects more than IDFC Ltd
IDFC Ltd appreciates and IDFC First stagnates or corrects.
IDFC Ltd stagnates or corrects slightly, and IDFC First corrects significantly.

Basically the price ratio of 1.33 (IDFC/ IDFC First) will get closer to 1.55 giving 15-16% returns. Of course there will be transaction costs, rollover inefficiencies, and one has to pay 30-35% tax.

The only risk that I see is somehow the merger decision is rolled back.