If you buy a product in Aurangabad (a Tier 2 city), that same product can be priced higher in Mumbai (a Metro), where you can sell it and earn a tidy profit. Arbitrage funds work similarly, although the buying and selling happen simultaneously.
What are arbitrage funds?
Arbitrage Funds make profits by exploiting the price differential of the same asset in different markets. They are hybrid mutual funds where according to the Securities and Exchange Board of India (SEBI), at least 65% of the fund’s assets must be in equities and equity-related securities. Moreover, the fund can invest the balance in debt and debt-related securities.
What is arbitrage?
Arbitrage is the simultaneous buying and selling of the same asset in different markets to enjoy risk-free profits. Let’s say a fund buys a particular asset priced at Rs 90 in Market A and sells the same in Market B, where the price is Rs 100. Then it earns a profit of Rs 10 from that asset. These profits are risk-free because both the buy and sell positions are 100% hedged. Also, since buying and selling happen simultaneously, the risk of price movement may get averted.
How Do Arbitrage Funds Work?
Arbitrage funds capitalise on price inefficiencies in the cash and derivatives markets. The cash market, or the spot market, is where transactions are settled on the spot. In futures, an asset is sold at a future date at a predetermined price. Thus, if a stock is trading at Rs 100 in the cash market and Rs 105 in the futures market, an arbitrage fund will buy the stock in the cash market, sell it in the futures market and make a risk-free profit of Rs 5 on the transaction.
Example of Arbitrage
Here's an example that illustrates in greater detail how the concept of arbitrage works and how it is insulated from price volatility.
Let us assume that the share price in the spot market at the time of purchase was Rs 100 and it was also simultaneously sold in the futures market for Rs 105. Below are the various scenarios of the share prices at Futures & Options expiry and the profits made under each scenario.
Price in the spot market at the time of purchase= Rs 100
Price at which the stock can be sold in the futures market= Rs 105
| Price on F&O expiry|
| Buy at 100 in spot market||10||-10||0|
|Sell at 105 in futures market ||-5||15||5|
Why and Who Should Invest in Arbitrage Funds?
First, since the simultaneous buy and sell transactions are 100% hedged, the price volatility risk is nullified. Second, arbitrage funds enable investors to enjoy the tax benefits of
equity funds. Thus, long-term capital gains attract a tax of 10% without indexation, short-term capital gains are taxed at 15%, and gains of up to Rs 1 Lakh are exempt. Third, counterparty risk is eliminated since the stock exchange guarantees the settlement of all futures contracts.
Investors with a low-risk appetite looking for better returns on short-term funds can consider arbitrage funds. A time horizon of more than three months works better because a lower duration can result in diminished returns due to volatility.
Factors to Consider before Investing in Arbitrage Funds
Since short selling by
mutual funds is not allowed in India, arbitrage can become a challenge in bearish conditions. Arbitrage funds can invest in debt and debt-related securities, which can carry credit risks.
Arbitrage funds take advantage of price inefficiencies in the cash and derivative markets. Investors should consider them if they align with their risk appetite and investment goals.
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