Arbitrage Funds are among the less popular mutual funds around.
However, this blog will bring to light how effective and useful arbitrage funds can be. Especially, under certain market environments, especially during extreme volatility.
Let me give you a simple scenario to help you understand the principle of arbitrage.
You are traveling to your native place. You see apples selling there for Rs. 80 per kilogram. You then recall that the price is Rs. 100 per kilogram in the city you live. Moreover, the quality of apples if identical.
A good business/profit-making idea could be to buy apples at Rs. 80 from your native place and sell them at Rs. 100 in your city! You will make Rs. 20 per kilogram of apple you sell.
For argument’s sake, we will ignore the risks and cost of transportation and everything else.
Just by exploiting the price difference, you could make a riskless profit! Riskless because you know what price you can buy and sell the apples at for sure.
In theory, the apples should have had the same price since they were of the same quality. But they didn’t and you capitalized on the price difference. Congratulations, you have just exploited an arbitrage opportunity!
What are Arbitrage Funds?
Arbitrage funds conduct arbitrage trades like the one we saw above. They do it with financial instruments and commodities instead of apples.
However, the above scenario had a number of practical risks associated with it.
What if the transportation costs are higher than the profit-making opportunity?
What if the apples rot on the way?
What if 1 in every 50 trips met with an accident?
These risks are absent when you deal with securities on a public exchange. So, ignoring the risks and costs in our context is acceptable.
An arbitrage trade in the stock market can take place in two primary ways –
- Between the spot and futures market
- Between two different exchanges
Arbitrage Trade – Spot (cash) and Future Markets
Let’s say share A is available for Rs. 8 in the spot market (also called cash market).
So, the fund manager can enter a futures contract that obliges him to deliver the stock at Rs. 10 (anything greater than Rs. 8 is acceptable) after 3 months. If he is able to find such a contract, he will immediately buy the shares at Rs. 8 in the spot market.
3 months later, he will sell the shares at Rs. 10 to the counter party of the futures contract thereby making a profit of Rs. 2 per share. (we ignore transaction costs to keep the discussion simple)
This is considered to be fairly safe. You know what price you are going to be able to sell at while buying the shares. The counter-party risk is also close to zero since the exchange is the counter-party.
This was a simple explanation of an arbitrage trade involving the cash and futures market.
Arbitrage Trade – Two Different Exchanges
Now consider two different exchanges like the BSE (Bombay Stock Exchange) and the NSE (National Stock Exchange)
Let’s consider share A which trades on both the exchanges.
It comes to your notice that it is trading at Rs. 100 on the BSE and at Rs. 102 on the NSE.
Recall the apples example above. Sounds similar, doesn’t it?
An arbitrage fund manager will buy sharesA on the BSE for Rs. 100 and simultaneously sell them on the BSE for Rs. 102. A risk-free profit of Rs. 2 per share. (again, we ignore costs)
This is also an example of an arbitrage trade.
Please note that arbitrage funds seek to exploit several other arbitrage opportunities. Moreover, these may not only be in the equity asset category.
The two types of arbitrage trade opportunities that we discussed above are among the most common ones exploited.
How risky are arbitrage funds?
For all practical purposes, an arbitrage trade is considered to be risk-free.
Why would someone pursue an arbitrage trade if it is not available, right? People can always speculate, but arbitrage fund managers rarely, if ever, would resort to speculation.
In other words, a rational investor will seek an arbitrage opportunity only if it is readily available.
However, this doesn’t mean arbitrage mutual funds are 100% risk-free.
We discuss the primary risks of arbitrage funds in a separate blog.
Additionally, we also discussed the expected returns in the blog. Stay tuned!
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