Sunday, September 13, 2009

Cadbury (CBY) - Using IV90 to analyze a cash & stock deal

Kraft (KFT) launched cash and stock bid for Cadbury last week for 300 pence (about $5.01) and 0.2589 shares of its stock. Cadbury rejected the offer saying the offer undervalues the company, and also the business models of the two companies do not match. Chairman Roger Carr says that Cadbury is more focused, and Kraft historically has lower growth.

What does this mean for the options?

We need to take a minute and step though the math. Each Cabdury ADR is worth 4 Cadbury shares traded in the UK. With KFT trading $26.10, this puts the bid price approximately $6.60 in KFT * 4 = $26.40 + $5.01 * 4 = $20.04, total of a bid price of $46.44. CBY is currently trading $51.82, about 12% higher than the deal price.

To actually study the options, first go to the options tab, check out the ATM straddle for Oct and Dec. The CBY Oct 50 straddle is 3.50 x 4.75, the CBY Dec 50 straddle is 5.35 x 6.80. Very wide indeed! There is not a lot of volume and open interest in Dec so putting a trade for a good price would be time consuming, is possible.

Next, check the summary area for both CBY and KFT and look at the IV90.

What’s really interesting here is the IV90 of KFT and the IV90 of CBY are about the same. For a $1 move in KFT, this would equal roughly a $1.03 move in CBY. Some very simple math here is that CBY is almost double the price of KFT, which should mean if the deal goes through the options in CBY should roughly be about half the implied volatility of KFT (plus some wiggle room for currency fluctuations).  

KFT currently has an IV90 of 27, CBY has an IV90 of 28. This is implying that all the future drama is worth about 14 volatility points. This is an oversimplified calculation, this does not fly if KFT goes up 25 bucks of course!
The most significant factors that could influence the volatility of CBY would be the following:

1. The board accepts a deal- meaning the long term volatilities should line up.
2. KFT increases the bid with a higher stock percentage, bringing up the volatility the options should trade at.
3. A white knight emerges. The market would probably keep the vols where they are suspecting a bidding war.

Under all scenarios the lack of liquidity is a huge turn off. Wide market mean having to proactively work orders to get the fills you want.  If I were to trade this I would probably want to limit myself to the front months which aren't as wide.

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