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Old Mutual makes arbitrage profits

At The Market with Tetrad

THE Zimbabwe Stock Exchange (ZSE) has remained skewed towards weakness for much of this year as changes in the investment climate, precipitated by the monetary policy statement

of December last year, have come into play.

Interest rate uncertainty has proved a damper on leveraged investments which was a major driver of commodity, currency, equity and property investments over the last couple of years given the huge negative differential that existed between inflation and interest rates. Of course, the thought of prosecution has played its part too in the investment equation as a lot of traders have gone underground for fear of finding themselves subject to scrutiny from the likes of Zimra and the police.

Along with falling disposable incomes which have led generally to businesses experiencing declining local demand for their products, a scenario that is likely to see earnings expectations not being exceeded in the same manner as the last three years, these factors have seen the industrial index gain just 12% in the year to March 3.

The mining index has done better, up 21% over the same period, but both with annualized returns of 44% and 84% respectively, have given investors little to cheer about.

Of the 82 listed counters, 40 have recorded gains during the period of between 1% and 171%; three have remained at year-end 2003 levels while 39 have experienced declines of between 5% and 79%.

It must be noted, to be fair, that Gulliver’s position as the worst performer is academic given that it reflects the result of the bonus or capitalisation issue of shares that saw three ordinary shares being issued for every one held by investors as at February 27 and the subsequent listing of those shares on the exchange. This had the impact of diluting the share price.

Old Mutual, a relative underperformer for much of the bull-run experienced over the past few years has seen its star rising once again this year.

This has been due to the implementation of the foreign currency auction system which has facilitated the arbitraging of Old Mutual shares. This arbitrage, which can be described as the process of taking advantage of countervailing prices in different markets by the purchase or sale of an instrument and simultaneous taking of an equal and opposite position in a related market to profit from small price differentials, is being enabled by the differential in exchange rates between the auction and the implied Old Mutual rate using the London Stock Exchange Old Mutual price.

Taking the latest United States dollar auction rate for purposes of the example, what some investors are doing is buying Old Mutual shares on the ZSE, which at Wednesday’s price of $5 950 are trading at an implied US dollar rate of $3 422: US$1, and then selling them on the London Stock Exchange.

When the proceeds of sale are then repatriated to Zimbabwe through the auction, the weighted average exchange rate received would be $4 214: US$1, the rate differential thus providing a tidy profit for investors, gross of transaction costs of course.

Arbitrage of course is nothing new, the advent of the global economy and financial systems having accelerated its growth over the years. International financier, speculator and philanthropist George Soros is one of the more famous proponents of arbitrage of our times.

Probably his most famous, (some would say infamous!), gamble, as described in a short biography of the man by Jennifer Smith, occurred in 1992, following which he was widely tagged “The man who broke the Bank of England.”

On this occasion, Soros bet that the British pound would have to be devalued because it had been sent to the European exchange rate mechanism at too high a rate. Knowing that the German central bank, Bundesbank, favored a devaluation of both the British pound and the Italian lira because of the disastrous impact that high British interest rates were having on asset prices, Soros spent the next few months building positions to short the British pound.

He borrowed pounds heavily, and converted them into a mixture of deutschmarks and French francs.

On Black Wednesday or November 16 1992, so named as this was the day the pound was forced out of the Exchange Rate Mechanism, a system for tying its value to that of other European currencies, as speculators sold pounds and the Bank of England was forced to devalue, his bet paid off. Soros reportedly made a profit of more than a US$1 billion, and was said to have cost every man, woman, and child in the United Kingdom 12 pounds following the Bank of England’s unsuccessful attempts to defend the currency! Financial World calculated that Soros’ pay was greater than the gross national product of 42 nations at the time.

Such astronomical profits are unlikely to be seen on our local market for many a year to come, but given the dearth of investment opportunities currently prevailing in the country as a whole, investors who are able will no doubt continue taking advantage of the arbitrage opportunity provided by Old Mutual, though the profits are relatively small, until market forces, as they inevitably do if unrestricted, close the arbitrage gap.

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