Arbitrage, in finance, equates to risk-free returns. The concept sounds confusing, as any return requires investors to assume a degree of risk, especially when they want returns above the level of bank deposits. Returns in financial markets are equivalent to profit in other markets.
Just as a trader buys at a lower cost in one market and sells at a higher price in another market to earn profit, investors in financial markets take advantage of different prices existing in different markets to make a profit. This difference is the return on the investment.
Arbitrage Funds – Cashing in on price differentials
Arbitrage Funds are Mutual Funds that take advantage of temporary price differentials of the same asset in the cash market and the derivative market.
The cash market is where shares are bought and sold at market or limit price for delivery. You pay the actual price of the shares prevalent at the time of purchase and the shares are delivered to your account.
The derivative market is different. Here, you can transact at a future date by fixing the price today. For example, you can agree to buy or sell one kilogram of Gold or a specific number of shares after a year at a price decided today. If the actual price after a year is more than what you decided today, you make a profit if you are buying or a loss if you are selling. If the actual price after a year is lesser, the situation reverses.
Additional Reading: Investments And Tax Tips For Those In The Highest Tax Bracket
When you combine these two transactions (cash market and derivative market), you create a situation where your risk is mitigated. Let’s look at an example.
Consider the share price of an imaginary company, ImagineCo. Its share price today is Rs. 1,000. The three months future price is Rs. 1,050. This means you can buy or sell ImagineCo shares at the end of three months at Rs. 1,050 if you wish so. So, by buying the ImagineCo three months future, you have locked in the price. At the end of three months, the actual share price in the market is, say, Rs. 1,060. This means you have made a profit of Rs 10 per share.
From a fund’s perspective, it can buy shares of ImagineCo at Rs. 1,000 and sell the three months future at Rs. 1,050. Now after three months, two things can happen. The prices can go down or can go up. Let’s take each scenario.
Scenario 1: The price goes up to Rs. 1,060 on the settlement day after three months. On the settlement day, the future price and price in the cash market converge. The fund can sell the stocks at Rs. 1,060 and make Rs. 60 as profit. In order to settle the futures contract purchased, the fund will need to buy futures. It will close the future position by buying the future at the same price of Rs. 1,060, incurring a loss of Rs. 10. The overall profit is Rs. 50.
Scenario 2: Suppose the share price goes down to Rs. 940. In this case, the fund will incur a loss of Rs. 60 in the cash market as it sells the share which it bought at Rs. 1,000. On the future side, however, it will make a profit of Rs. 110 as the fund had sold it for Rs. 1,050. Overall the profit will be Rs. 50, as before.
Hence, irrespective of the direction of price movement, the investor has made money. In all our calculations, we have ignored transaction costs which form a small proportion of your profit.
The advantage of Arbitrage Funds
Arbitrage Funds are for conservative investors who cannot take the risk associated with pure equity investing through Mutual Funds. Arbitrage Funds are a low-risk investment with average returns. They are very similar to Debt Funds where the risk is low.
However, what works in favour of Arbitrage Funds over Debt Funds is the tax advantage associated with it. Since Arbitrage Funds are categorised as equity funds, the capital gains tax is nil for long- term investments, i.e. for more than a year. In case of Debt Funds, the taxes are both for short-term and long-term capital gains.
Additional Reading: All About Capital Gains Taxes