Presented by: Jyothi p

Index futures indicates the investors expectation

about the future course of the stock market. When investors are optimistic, the futures price is higher than the current level of the market and in times of pessimism, the futures price is lower than the current market level.

MEANING: Arbitrage is the practice of taking advantage of a price difference between two or

more markets, an arbitrage is a transaction that

involves no negative cash flow at any probabilistic or temporal state and a positive cash flow in at least one

state; in simple terms, it is the possibility of a risk-free

profit at zero cost.

When there is a relatively large divergence

arbitrageurs make a profit out of it. Arbitrageur is a person who simultaneously purchases and sells the same or essentially similar security in two different markets for advantageously different prices

To illustrate this with a hypothetical example, let us take a day in July when the NSE nifty index futures is selling for Rs 220 and the NSE Nifty index is at 200. two investment strategies can be followed.

1. purchase the stocks in the Nifty, hold them until

December and then sell them on the delivery date of the December Nifty futures contract

2. Purchase the December Nifty futures contract

along with the treasury bills that mature in December. Keep the futures contract until the delivery date in December.

To start with, strategy one would cost Rs 200 in the index terms. If the investor holds on till December he could get two benefits

A) an amount of ,money equal to the value of nifty, on

the delivery and

B) dividends on the stocks that went ex-dividend prior to the delivery date.

The investor would get IE + D that is index price at expiration and the dividend

Let us assume dividend yield for a six month time

period from June to December is 4%, then the investor gain

=IE+ (0.04*200) =IE+ Rs 8

Now the investor has invested his money Rs 200 in treasury bills. Because treasury bills can be used as margin in futures, he has bought a futures contract worth of Rs 220. the total cost of strategy 2 is Rs 200,

which is the same as the cost of strategy 1.

The strategy 2 yields a return of

A)difference between the value of the nifty and Rs 220 on the delivery date

B)Face value of the treasury bills on the date and the

yield from it. The yield on the treasury bill is 5%. Now the investor will receive = FE-FC+(1.05*Rs 200) Here FC current futures price And FE futures price at expiration =FE-220+210 Net cash flow= FE-10

Arbitrage, both the strategies require the same initial outlay and the uncertainty faced by the strategies are equal. The index price level in FE is not known. When the net cash inflow are not equal in December, there is an opportunity for arbitrage. The investor can go for long or buy in strategy 1 and sell or short in strategy 2.. Because strategy 1 pays higher than the

strategy 2 i.e. IE + 8> FE-10

He can buy the index shares at and keep them till December and sell the index futures and the treasury

bills that mature in December. It is assumed that the

investor is having treasury bills in his portfolio. The net cash expenditure or outflow experienced by investor is

nil. He spends Rs 200 to buy index shares and sells 200

worth of treasury bills . The margin required to go short in the future index is the underlying shares itself.

Now by spending Rs 200 to purchase the index stock

and using it as margin can go short and sell index futures for Rs 220. now if the index remains at 200 level and the arbitrageur can gain Rs 20 at the expiration date by getting Rs 220 from the index

futures. Further, he would also get dividend from the

index stocks he has purchased i.e. Rs (=0.04*200) . But he has to forego the interest from the treasury bills that is Rs 5(=0.05*200).

Now the net gain is

=gain from the index futures +dividend gain from

index stocks interest from the treasury bills

=Rs(220-200)+(0.04*200)-(0.05*200) =Rs20+8-10 =Rs 18 Thus by going long in strategy 1 and short in strategy 2, his risk is nil but he has increased his potential gain to Rs 18 from 8 if the index remains at Rs 200