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Arbitrage

# Arbitrage

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09/11/2011

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Page 1
Implied Volatility
Derivative Classroom -Series

V

Derivative ClassroomArbitrage-
Series VIII

November 18, 2009 `

An arbitrage is the practice of capitalizing on mis-pricing existing between twomarkets. It is a combination of deals that takes advantage of the imbalanceprevailing in cash and future market. In the field of investing, arbitrage can bebifurcated into two types- Deterministic Arbitrage and Statistical Arbitrage
Deterministic Arbitrage
In deterministic arbitrage a sure profit can be obtained from being long somesecurities and short othersExample:1.

Cash and carry Arbitrage2.

Reverse Cash and Carry Arbitrage
Statistical Arbitrage
Statistical Arbitrage attempts to profit from pricing inefficiencies identified withmathematical models. Statistical arbitrage attempts to profit from the probabilitythat prices will move toward a historical average. Unlike Deterministic arbitrage,statistical arbitrage has risk.Example:1.

Pair Strategy Arbitrage
Arbitrage
Spot Price Future Price
Karun Mutha

Tel +91-22-67897833Email:Karun.mutha@hsbcinv.com
Tina Khetan
Analyst - Derivatives
Tel +91-22-67897828

Email:Tina.khetan@hsbcinv.com
I- Cash and Carry Arbitrage

Cash and carry arbitrage entails making profit from the price differentialbetween cash and futures market, when the basis is positive (Future is quotingat a premium).Basis = Futures price- Cash PriceDuring the month basis can turn in to premium or discount. However as timedecays future price starts converging cash price and eventually expire at theclosing of cash price (VWAP) on expiry.Profit: (Future price- Cash Price)*Qty
Illustration 1
Suppose Larsen & Turbo November future is quoting at a premium of Rs.25.00.Mr. Shah is a conservative investor and wants to make a risk less profit. He canexecute the following trade. Lot size: 200
LT Cash 1600.00 1710.00
Sell
LT Futures 1630.00 1710.00 15.27 30.00
Difference 30.00 0.00
Long on stock, Buy PutView: Extremely bullishBasis

Page 2
Implied Volatility
Derivative Classroom -Series

V

Derivative ClassroomArbitrage-
Series VIII

Reverse Cash and Carry arbitrage opportunity arises when future is quoting at adiscount to cash price.Profit = (Cash price of stock – Future price of Stock) * Qty.
Illustration II
Suppose Mr. Mehta has 1500 shares of Sesa Goa. Currently Sesa Goa is quotingat a discount of Rs.10.00. Following trade can be executed
LT Futures 335.00 290.00
Sell
LT Cash 345.00 290.00 24.18 30.00
Difference 10.00 0.00
Long on stock, sell a call optionView: Neutral/ moderately bullish
III-Pair Strategy Arbitrage
Buying a lower strike Call and sellinghigher strike callView: Bullish
II- Reverse Cash and Carry Arbitrage
As a trading strategy, statistical arbitrage is a quantitative and computationalapproach to equity trading. It involves data mining and statistical methods.Pair trading strategy is one of the statistical arbitrage, in which stocks are putinto pairs based on quantitative simulation or market-based similarities. Whenone stock in a pair outperforms the other, the poorer performing stock is boughtlong with the expectation that it will climb towards its outperforming partner,the other is sold short.Example:1.

Buy HDFC – Sell Rel Capital
IV-Corporate Action based Arbitrage
Corporate action like Open Offer, Buy back, Mergers and Acquisition too providevarious arbitrage opportunities. In open offer and buy back risk – reward isdetermined based on acceptance ratio and we can hedged the likely unacceptedshares using futures contract. Profitability varies depending on the purchaseprice of shares, days for acceptance and acceptance ratio.

Profit: (Cash Price of stock- FuturePrice of stock) * Qty