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Arbitrage Funds

Arbitrage Funds

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Published by muthuramesh88

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Published by: muthuramesh88 on Sep 26, 2009
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Why should one invest in Arbitrage Funds?
October 11, 2006 15:11 IST
here has been a spate of derivative or arbitrage funds being launched, the most recent one being
. What is an arbitrage fund and what should investors look for beforeinvesting in one? The article addresses these and related issues.But first a little background. Sometime back the markets were at an all time peak. And then the muchfeared correction arrived. Just when investors were almost giving up hope, the market turnedaroundand crossed the 12000 mark again. In such volatile situations, what is an investor supposed to do?Most astute investors book profits at regular intervals and milestones. And then when the valuationsfall, they buy into bargains. Buy low and sell high is the only way to make money on the stockmarkets and those who actually do end up making the money follow this mantra regularly. (Also read- 
)Anyway, say you have sold some shares and booked profits. What will you do with the money?Some money can go back into stocks. But at this point you might not want to commit all your fundsto equity. At the same time, you wouldn't want to lock up your funds for any length of time. You never know when the market will provide an opportunity next and you will like to keep your moneyreasonably liquid.Income funds are not the answer. Interest rates being on the upswing investors would have toundertake a heavy "interest rate risk".Interest rates and prices of fixed income instruments share an inverse relationship. In other words,when the overall interest rates in the economy rise, the prices of fixed income earning instrumentsfall and vice versa. Therefore, in the past when interest rates were falling linearly year after year,most income funds yielded returns that even a well doing equity fund would be proud of. This is doneby adjusting the portfolio to the market rate of returns is called 'Mark to market'. However, this article
is not about the mechanics of the interest rate risk. (Also read -
)In simple words, when interest rates in the economy rise, the NAV of an income fund falls and viceversa. Therefore, as of now, investors have to look elsewheresome
place that gives them fixedreturn at a very low risk.
Enter Arbitrage Funds
Investors not familiar with this type of scheme might just end up thinking that these are just equity-oriented schemes with another fancy name. However, this is not so. What such funds aim to do is totake advantage of the arbitrage opportunities between the cash and the futures market to generatefixed income. Therefore, these are a type of income scheme.he arbitragTe is sought by taking advantage of the mispricing between the cash and the derivativesmarket. Let's understand how this works. (Also read -
)Suppose the stock price of XYZ Ltd. is quoting at Rs. 600. Let's say the stock is also traded inderivatives segment, where its future price is Rs. 610. In such a case, one can make a risk-free profitby selling a futures contract of XYZ Ltd. at Rs. 610 and buy an equivalent number of shares in theequity market at Rs. 600.Now when settlement day arrives, it wouldn't matter which direction the stock price of XYZ Ltd. hastaken in the interim. In other words, it is irrelevant whether the share price of XYZ Ltd. has risen or fallen, one would still make the same amount of money.This happens because on the date of expiry (settlement date) the price of the equity shares and their stock futures will tend to coincide. Now, all one has to do is to reverse the initial transaction i.e. buyback the contract in the futures market and sell off the equity. So four transactions have taken place--- buy stock, sell futures, sell stock, buy futures. In this manner, irrespective of the share price, theinvestor earns the spread between the purchase price of the equity shares and the sale price of futures contract.Examine the following table
 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.
To Conclude
XYZ Price at settlement 700500Profit/Loss on sale of equityshares at expiry100-100Profit/Loss on purchase of stock Future at expiry-90110
Net Profit1010

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