Arbitrage
Arbitrage is the profit earned from buying and selling the same security or portfolio at different prices in quick succession or near simultaneously. It yields riskless profit.
Example
Say, an equity share is priced at Rs 61.50 on the NSE whereas the same share is selling for Rs 61.55 on the BSE. Assuming intraday exchange trading is allowed, If one buys the stock on NSE and sells it on BSE, there is an arbitrage of Rs 0.05 to be earned on each share.
What is risk-free arbitrage?
Arbitrage can be earned because of inefficiencies in money markets such as pricing inefficiency and information inefficiency. Therefore, there is no risk while indulging in an arbitrage activity.
Is arbitrage still possible?
Yes. However, in India, increasingly efficient markets, which are algorithm-driven, are reducing the chances to earn arbitrage. Any price discrepancy on the same security across markets are acted upon by algorithms of their information systems and corrected within seconds. The prices converge to their fair value (as perceived by the markets) quickly, as a result, and the scope to profit consistently from a simultaneous lower and higher price is slim.
Who are Arbitrageurs?
A person who engages in Arbitrage is known as an Arbitrageur.
How does one know that an Arbitrage opportunity exists?
To find out whether an Arbitrage opportunity exists or not, one needs to constantly track two or more markets. If the calculations show that there can be a price difference in a span of a few minutes between two markets, it is said to be an arbitrage opportunity.
Is Arbitrage Legal?
Arbitrage is considered legal in India as it contributes to Market efficiency as well as provides liquidity in the market.
What is the difference between Hedgers, Speculators, and Arbitrageurs?
Hedgers try to minimize the risk that is associated with uncertain events, basically hedging against uncertain events
Speculators places bet against the movement of the market to earn a profit out of the fluctuations in the market
Arbitrageurs earn by identifying the difference in prices in two markets and buying at a lower price from one market and selling at a higher price in the secondary market
What are the various types of Arbitrage?
- Spatial Arbitrage
- Statistical Arbitrage
- Depository Receipts
- Merger Arbitrage
- Convertible Bond Arbitrage
- Municipal Bond Arbitrage
- Dual Listed companies
- Regulatory Arbitrage
- Cross-border Arbitrage
- Telecom Arbitrage
- Private to Public equities
Arbitrage Funds
Arbitrage funds meaning
Arbitrage fund is a type of mutual fund that aims to exploits arbitrage opportunities that arise due to mispricing in the spot and the futures market. These funds take a long position in the spot market and simultaneously sell them in the future market. This allows them to buy the stock in the lower-priced spot market and sell it in the higher-price futures market.
Irrespective of subsequent price movements, the difference in the prices between the two markets is the fund’s return. For instance, assume a stock trades at Rs 100 in the spot market and the near-month (one month) future on the stock trades at Rs 102. This price differential of Rs 2 is locked-in, irrespective of the price at the settlement date.
Arbitrage Funds in India
| Fund Name (Growth) | 1Y Return (%) | Fund Size (Rs Cr) |
| L&T Arbitrage Opportunity Fund | 5.00 | 2736.80 |
| Tata Arbitrate Fund | 5.44 | 2813.81 |
| Kotak Equity Arbitrage Fund | 4.59 | 14,908.39 |
| Nippon India Arbitrage Fund | 4.73 | 8,028.81 |
| Edelweiss Arbitrage Fund | 4.89 | 3195.23 |
| UTI Arbitrage Fund | 4.62 | 2969.28 |
| IDFC Arbitrage Fund | 4.27 | 6670.06 |
| ICICI Prudential Equity- Arbitrage Fund | 4.48 | 9441.43 |
| Aditya Birla Sun Life Arbitrage Fund | 4.40 | 3335.35 |
| SBI Arbitrage Opportunity Fund | 3.60 | 2928.70 |
Source: Tavaga Research
Arbitrage Funds Taxation
Tax treatment for these funds are similar to equity funds. For instance, if an investor has made a capital gain of Rs 100,000 on investment in an arbitrage fund and decides to withdraw the amount within 1 year, a short-term capital gain of 15 percent would be levied on that investor. Therefore, the tax payable in this case becomes Rs 15,000.
On the other hand, if an investor makes a capital gain amounting to Rs 1.5 lakh in an arbitrage fund and withdraws the amount after 1 year, the investor would be taxed at 10 percent on Rs 50,000. The taxable amount in this case become Rs 5,000. Capital gains up to Rs 100,000 are exempt from long term capital gains tax.
Arbitrage funds vs liquid funds
These two funds are very different in nature, although the returns on the two funds are quite comparable. The reason for this is the difference between the spot and futures market is largely a reflection of the short-term interest rate. For arbitrage funds, the additional returns, if any, come from the mis-priced opportunities, due to market inefficiencies.
Arbitrage Pricing Theory
Arbitrage Pricing Theory (APT) is an alternative to the Capital Asset Pricing Theory (CAPM). It provides investors with an estimated required rate of return on risky securities. The theory of APT proposes that an asset’s returns can be forecasted as a linear relationship between an asset’s return and macroeconomic factors that affect the asset’s risk. The APT theory was created by an American economist, Stephen Ross, in 1976.