Let us first understand the concept of arbitrage.
- You notice that a mobile phone online costs Rs. 50,000.
- A colleague of yours plans to buy the same phone from a retail store for Rs. 55,000.
- Seeing the opportunity for a risk-free profit you purchase the phone online for Rs. 50,000 and then simultaneously sell it to your colleague for Rs. 55,000.
- This was an arbitrage profit of Rs. 5,000.
Simply, arbitrage implies taking advantage, of a difference in price of the same asset in two different markets, at the same time. This enables one to buy at a cheaper price and sell the same at a higher price, resulting in a "risk-free" profit.
Arbitrage mutual funds earn profits through the simultaneous purchase and sale of securities on two different exchanges. The spot-cash market and the futures market.
The spot-cash market is where a stock can be bought or sold at the current price. While the futures market, as the name would suggest, lets you buy or sell a stock at a pre-determined, future price.
The difference between the spot price and the futures price creates arbitrage opportunities.
Let’s look at an example:
- Stock A is trading at Rs.200 today. This is the spot price. (Therefore, Stock A can be bought OR sold today for Rs. 200.)
- In the Futures market, the same Stock A is trading at a 1-month futures price of Rs. 201. Therefore, Stock A can be purchased OR sold after 1 month for Rs. 201.
The Arbitrage Fund would simultaneously make two transactions. To BUY…. where the price is cheaper. And SELL... where it is higher.
In our example:
- BUY Stock A in the Spot market at Rs. 200
- AND, simultaneously, SELL Stock A at a 1-month future price of Rs. 201
Effectively, locking in a Rs. 1 arbitrage profit, over a period of 1 month, with an investment of Rs. 200.
Now, irrespective of the price of Stock A after 1-month, your profit is locked-in. Whether the price of Stock A rises to 250 or drops to 150. You will earn a profit of Rs. 1.
The benefits of arbitrage mutual funds are as follows:
Moderately Low Risk
One of the benefits of arbitrage funds is that they are moderately low risk. Because each security is bought and sold simultaneously, there is virtually no counterparty risk. The clearinghouse guarantees that the futures contract will be honored therefore eliminating counterparty risk.
Interest return
The clearinghouse takes some percentage of the portfolio as fixed deposit to give this guarantee. Thus, generating an interest return for the investor.
Returns
The returns generated from an arbitrage fund may be comparable to those accrued by short-term debt.
Taxation
Arbitrage funds benefit from equity taxation and have the potential to generate better post tax returns over other short-term debt funds especially when used to park money.
The time horizon for investing in arbitrage funds should at least 3 months.
To learn more about how you can best take advantage of arbitrage funds, contact your investment advisor.
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