In Scenario I, XYZ Ltd.skyrockets to Rs. 700on the settlement date.At this point, the pricewill be same in theequity and futures markets. So when you sell the stock, a profit of Rs. 100 is earned. However, youalso buy back the stock future thereby incurring a loss of Rs. 90. End result, a net profit of Rs. 10 isearned. The same thing happens even in Scenario II where the share price crashes to Rs. 500. Stillyou will end up with same profit.Yes, it does sound like a very simple and effective way of making money in the market. After all, theproblem that most investors have with entering into the equity market is the lack of assured risk freereturns. And now here is a product that gives you exactly that. However, if only life were indeed thatsimple.The first hurdle is the presence of arbitrage opportunities. In a given period of time, the market mayor may not provide any meaningful arbitrage opportunities. And as explained above, it is thesearbitrage opportunities that hold the key to the amount of money the fund will earn. No doubt, thefund management team will have to be extra vigilant in identifying such opportunities.Of course, nowadays, they have sophisticated softwares that flag such mispricing the moment itoccurs. However, investors do have to take into account the uncertainty of the supply of arbitrage asa hurdle in earning returns. For this very reason, such schemes cannot assure returns, the returnstotally and completely depend upon available opportunity.Secondly, there is the issue of costs. Each transaction in the stock market involves payment of brokerage and security transaction tax (STT). These costs directly dilute the earnings. Each leg of the entire transaction i.e. buying stock, selling future, selling stock and buying futures will entail thepayment of these costs. Therefore, it again comes down to the presence of the arbitrage opportunityand it being meaningful enough i.e., after the payment of the expenses, the left over profit if any,should be material enough to make the transaction worth entering into.
XYZ Price at settlement 700500Profit/Loss on sale of equityshares at expiry100-100Profit/Loss on purchase of stock Future at expiry-90110