What is Arbitrage?
Arbitrage is simultaneous buying and selling the same underlying security or its derivatives in different market segments to make risk free profits. If the price of the same object is different in different markets, you can make risk free
profits by buying the object in the market where price is lower and simultaneously selling it in the market where price is higher. It is important that both the buy and sell transactions are executed simultaneously so that you can lock-in
the profits and not be exposed to price risks. Since arbitrageurs aim to make risk free profits the buy and sell positions are totally (100%) hedged.
How does cash and carry arbitrage work?
Examples of different arbitrage opportunities
- Exchange arbitrage: Price of the same security is different in two stock exchanges e.g. share of a company is trading at Rs 100 in NSE and Rs 101 in BSE. You can lock-in Rs 1 profit / share by simultaneously buying
it in NSE and selling it in BSE.
- Index and basket of stocks arbitrage: This is essentially same as cash and carry arbitrage ‒ the only difference is that instead of a single stock here the arbitrage is for the index. For example, Nifty is trading
at Rs 9,300 in the F&O market whereas equivalent price of a basket of stocks constituting Nifty (in the same proportion as the index) is Rs 9275 in the cash market. You can lock-in Rs 25 How does profit per Nifty future contract by
simultaneously selling Nifty and buying the basket of stocks in the cash market.
- Cash and carry arbitrage: : Price of the share of a company in the cash market is Rs 1785 and price of the current series future of the same company in the Futures and Options (F&O) market is Rs 1794. You
can lock-in Rs 9 profit / share by simultaneously buying the share in cash market and selling it in the future market. Cash and carry arbitrage is the most common arbitrage strategy used by arbitrage mutual funds.
How will you make Arbitrage Profit?
By buying in the cash market and selling in the F&O market you will lock-in the profits irrespective of the price movement of the security because on expiry of the future contract (last Thursday of the month) the cash price and future
price will converge.
- Arbitrage opportunities created by corporate actions/events
- Rights issue: This is announced for a company’s existing investors when it needs more capital. The company gives an option or ‘rights’ to an existing investor to buy new shares at a discounted price during
a certain period. This offers an arbitrage opportunity as the investor can buy shares at a discount and sell the same when it matches the market price.
- Mergers and acquisitions (M&A): Merger arbitrage involves trading in the stocks of two merging firms based on their share swap ratio.
- Buy-Back Arbitrage: : When the company announces the buy-back of its own shares, there could be opportunities due to price differential in buyback price and trade price.
The advantages that these funds provide for investors are:
- Historic stable performance: Arbitrage funds have given stable positive returns of ~6% in past one year, despite the recent bloodbath in the broader market, which saw the Nifty 50 plunge 18.5% during the period.
Further, the category has beaten its benchmark and the market benchmark across point-to-point periods analysed.
- Opportunity across market scenarios:Arbitrage opportunities are available across market scenarios. In a bullish market or upswing, futures are usually priced higher than cash, thereby creating an opportunity to
sell futures of the stock in the derivatives market and buy the stock in the cash market. And in a volatile market as well, as is the current phase, arbitrage opportunities arise as mispricing is high. In fact, while arbitrage funds aim
to provide stable returns during bull and bear phases and in volatile phases, like the one we are seeing currently. This can be showcased, in terms of the arbitrage funds’ performance across market phases:
- Arbitrage Funds versus Debt Funds
A major advantage enjoyed by arbitrage funds is that of equity taxation. While profits made in debt funds held for less than 36 months is taxed as per the income tax rate of the investors, profits made in arbitrage funds held for less than 12
months (short term capital gains) is taxed at 15% plus applicable surcharge and cess. If units of arbitrage funds are sold after 12 months from date of purchase then profits (long term capital gains) of up to Rs 1 lakh are tax exempt in a
financial year. Long term capital gains in excess of Rs 1 lakh are taxed at 10% only.
Conclusion - Why invest in Arbitrage Funds
- Low risk (arbitrage theoretically means risk free profits)
- Low volatility
- Has the ability to match or outperform low risk debt funds pre-tax returns
- Ideal for a few months to more than one year investment tenures
- Tax efficiency (equity taxation)
It is always advisable to consult your financial advisor before investing.
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