Arbitrage funds - for short term parking of funds

Please click on the link here to read the article, published in Mid-day Gujarati, Mumbai edition on 6th February, 2017

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The English translation is as under:

In the last few years, one of the mutual fund categories has become quite popular – especially among individual investors intending to park money for short periods of time. This category is known as “arbitrage funds”.

As such, the name does not indicate anything, especially for the uninitiated investors or someone who is less familiar. However, these funds are among the safer funds in that they do behave almost like liquid funds. As mentioned earlier, these funds may be considered for parking money for short periods like a month or a quarter or so.

Let us understand how these funds work.

The term arbitrage means “simultaneous buying and selling of same securities, commodities, or foreign exchange in different markets to profit from unequal prices.” Arbitrage requires two separate markets and a price difference in these markets for the same security. Since one is simultaneously buying the cheaper one and selling the costlier one, this is a profit-making opportunity without involving any risk.

In reality, there could be transaction costs involved in both buying as well as selling. These costs need to be adjusted before arriving at the profit number. Such anomalies do exist at times and many players take advantage of the same.

Lest us elaborate on this in the Indian context through the example of arbitrage opportunities in stock markets.

On 3^rd February, Axis Bank stock closed at Rs. 489.90 on the National Stock Exchange and at Rs. 489.65 on the Bombay Stock Exchange (both prices are taken from the cash market segment). If someone could buy on BSE and sell on NSE simultaneously at the closing price, there was a net profit of Rs. 0.25 per share, assuming the transaction costs to be zero. (For the purpose of this discussion and example, we would assume the transaction costs to be zero. For simplicity, we are also assuming that one has to deliver the shares at the NSE only after receiving the same from the BSE.)

Since both purchase and sale happened simultaneously, there is no risk involved – whatever happens to the price of the stock. The profit of Rs. 0.25 per share on a share price of Rs. 489.65 translates into a profit of 0.051% for a day, or 18.64% per year. Please understand that this calculation is based on the assumption that the transaction costs are zero. Once you adjust for the costs, there is no profit opportunity left.

On the other hand, there is generally a price difference between the cash market and the derivatives market. Taking the example of Axis Bank once again, on the BSE cash market segment, the closing price was Rs. 489.65 and that for Axis Bank futures (expiring on 23^rd February) was Rs. 491.30. This meant that the futures price is higher than the cash market price by Rs. 1.65 per share. Someone can profit from this opportunity (once again, this calculation is without factoring the transaction costs) by buying the shares in the cash market segment and selling the futures. The futures contract would automatically expire on 23^rd February, whereas the shares bought on cash market must be sold on the same day. That means, the investor would be investing Rs. 489.65 per share for 20 days and earn a profit of Rs. 1.65 for the same. This translates into an annual profit of 6.15%.

If during the 20 day period, share prices go up, one would profit on the cash market – the shares bought, whereas lose on the futures market – futures contracts sole. If the prices go down, it would be reverse, i.e. loss in the cash market segment and profit in the futures market. Thus, theoretically, one has pocketed the annualized profit of 6.15%, irrespective to what happens to the price thereafter. This is why such trade is considered risk-free.

Arbitrage funds take the advantage of such opportunities.

At the same time, as we have seen in the numbers, most of the time, the profit is in the range of the returns liquid funds can generate.

Since these funds invest in the stock market, such funds may get classified as equity funds for the purpose of income tax. That makes these funds very attractive as compared to liquid funds.

- Amit Trivedi