Arbitrage funds are a category of Mutual Funds that are often overlooked by investors.
To understand how arbitrage funds works, we must first understand the concept of arbitrage.
Arbitrage is an investment strategy that looks to capitalize on the price difference of a single commodity or asset in two different markets.
So, if the price of a particular variety of Mango is Rs. 100 in Market A and Rs 80 in Market B, an arbitrageur can earn arbitrage profit by buying Mangoes in Market B (where the price the less) and then selling them in Market A (where the price is higher).
Note that in the above example, an arbitrage opportunity would only exist if the cost of transporting the mangoes from Market B to Market A is less than the price differential.
Arbitrage Opportunities in the Stock Market!
Arbitrage funds are Mutual Funds that play the arbitrage strategy by capitalizing on the difference in the price of securities (i.e equity) in two different markets.
Let us elaborate this a little further.
We know that there are two segments in the equity market:
- The Spot Market
- The Futures & Options (F&O) Market which is a derivative market segment.
The Spot Market is the market segment where securities are traded, in intraday or delivery based transactions, at the spot or current market price.
In the spot market the buy or sell transactions are intended for immediate settlement; though the actual delivery of shares or cash may time time depending upon the settlement cycle followed by the stock exchange. For example, in India the NSE and the BSE follow a T + 2 settlement cycle.
In contrast to this is the Futures & Options (F&O) Market where security contracts traded today are intended to be settled at a future date.
A Futures contract is a contract between two parties to buy and sell a standardized quantity of a security, on a given ‘future’ date, at a pre-determined price.
An Options contract is a contract that give you an option (a right but not an obligation) to buy/sell a security at a pre-determined price at a future date.
You would notice that there exists a difference between the spot price and the futures prices of a security in the two market segments.
The futures price i.e the price of buying a futures contract on a security is typically higher than the spot price and the difference between the two is on account of a factor which is known as ‘cost of carry‘ in financial parlance.
Let us try and understand what cost of carry actually represents.
We already know that in the spot market the settlement of cash and securities is always immediate. However, in the futures market the settlement takes place on the contract expiry date.
It is also helpful to understand that in the futures market, the settlement is always on a net-basis and that there is no actual delivery of the securities.
Let us assume that, you want to buy 100 shares of company X with the intention of selling them after one month, as you expect the share price to rise in the intervening period.
Now, if you acquire the 100 share in the spot market, you need to pay the full purchase immediately and take delivery of the 100 shares.
However, you can also enter into the same transaction in the futures market by buying a futures contract equivalent to 100 shares of company X with an expiry of one month.
Since the futures contract is intended to be settled after one month, the purchaser is not required to make an upfront payment of the full purchase price, but is only required to a maintain a fractional margin in this trading account.
On the settlement date, which is the contract expiry date, he either receives or pays the difference between the purchase price and the closing price (upon contract expiry), on his 100 shares depending upon the actual movement in share price in the intervening period.
Note that we have already said that futures contracts are always net-settled without there being an actual delivery of the underlying shares.
Now, since the person operating in the futures market is not required to pay the purchase price upfront, he can technically make an additional gain over the person operating in the spot market by investing the purchase price in a risk free instrument till the contract settlement date.
The markets however are thus structured that the cost of carry is built into the futures price of the contract. This denies the futures player any undue advantage over the spot market investor.
Thus, Futures price = Spot Price + Cost of Carry
Arbitrage funds position themselves to gain from this price difference between the spot and futures price of the securities by earning a risk free rate of return.
How Do Arbitrage Funds Work?
We already know that arbitrage funds profit from the price difference of securities in the spot and futures market.
Arbitrage Funds profit by taking opposite positions in the spot and futures market segment and then holding these positions till contract expiry.
Futures contract have an expiry date on which the contract is supposed to be settled.
Note that in case of futures contract, the settlement price, i.e price at which the settlement takes place is always equal to the spot price of the underlying security on the contract expiry date.
Thus the spot price and the futures price congregate upon contract expiry. Arbitrage funds take advantage of this by holding opposite positions in the spot and futures market till contract expiry and earning themselves a profit which represents the price difference between the spot and futures prices at the time of entering into the contract.
How arbitrage funds make money is better understood with an example.
Let us assume that the shares of Corp X are currently trading at Rs. 100 per share in the spot market. A futures contract of 100 shares of Corp X with an expiry of 1 month is trading at Rs. 105 per share.
The fund manager of the Arbitrage Fund, acquires 100 shares of Corp X for Rs 100 in the spot market. At the same time, he sells a futures contract representing 100 Corp X shares at Rs 105 per share.
On the contract expiry date, the share price in the spot market would either have gone up or down. We will analyse both the situations to see how much money the fund makes.
Situation 1: The share price moves up to Rs. 120 per share.
The fund manager had bought 100 shares at Rs. 100 per share. Since the price has moved up to Rs. 120 per share, the fund house makes a profit of Rs. 2,000 in the spot market.
In the futures market, however, the fund house incurs a loss. They had sold the futures contract equivalent to 100 Corp X shares at Rs. 105 per share. Now, since the contract expiry price is Rs. 120 (equal to the closing spot price) they make a loss of Rs. 1500 which is Rs. (120 – 105) x 100 shares.
Note that this is equivalent to buying back the shares at Rs. 120 per share.
Thus, the net profit made by the fund house is Rs. 500 (Rs. 2000 – Rs. 1500).
Situation 2: The share price falls to Rs. 80 per share.
The fund manager had bought 100 shares at Rs. 100 per share. Since the price has gone down to Rs. 80 per share, the fund house makes a loss of Rs. 2,000 in the spot market.
In the futures market, however, the fund house makes a profit. They had sold the futures contract equivalent to 100 Corp X shares at Rs. 105 per share. Now, since the contract expiry price is Rs. 80 (equivalent to the closing spot price) they make a profit of Rs. 2500 which is Rs. (105 – 80) x 100 shares.
Note that this is equivalent to buying back the shares at Rs. 80 per share.
Thus, the net profit made by the fund house is Rs. 500 (Rs. 2500 – Rs. 2000).
Note that in both the cases the profit made by the fund house is Rs. 500. This you would realize is the difference between the spot price (Rs. 100) and the Futures Price (Rs. 105) multiplied by the number of shares (which in this case is 100).
Thus, in both the cases, irrespective of the direction in which the share price actually moves, the fund house earns a risk free return representing the difference between spot and futures price.
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