Arbitrage involves the concurrent purchase and sale of identical or equivalent underlyings from two or more markets to benefit from their price differential. In the Indian context, arbitrage is largely concentrated in stock futures; index arbitrage is not very popular yet. Futures contracts were formally introduced in 2000.
However, Indian players are not new to forward transactions. In fact, the single stock futures of India generate more volumes than anywhere else in the world. Badla was a common practice.
Earlier, the price of the same stock often differed across exchanges. Hence, it was easy to realise gains buying on one exchange and selling at a higher price on another. However, real-time transfer of information has substantially reduced the difference between prices of the same stock on different exchanges. Now the play is more on price differences in the cash and futures markets.
In arbitrage transactions, returns depend on the difference between futures price and cash price at the time the transaction is initiated. On settlement date, the fund manager reverses transactions— he sells the shares and buys the futures. The fund manager will profit irrespective of prices on the settlement date.
It is irrelevant whether the share price has risen or fallen. Four transactions take place— buy stock, sell futures, sell stock, buy futures and the return is the spread between the purchase price of the share and the sale price of the future. A fund may roll its positions from current month to next month (called “short rollover”). The same will be carried forward every month till the futures quote at a discount to spot price, whereupon the position is reversed.
Arbitrage funds are gaining acceptance. Since their debut in 2004, various asset management companies (AMCs) like Prudential ICICI, JM, Standard Chartered, UTI, SBI, Kotak have launched these schemes. An arbitrage fund aims to beat debt returns through equity plays minus volatility. In the past year most have an average return of 7%-plus.
However, there are a few shortcomings. In a given period, there may not be meaningful arbitrage opportunities. AMCs are working out alternate arbitrages.
In view of tax advantages going away from traditional avenues, rising inflation and the increasing acceptance of mutual funds, arbitrage funds offer a promising bet from risk.
(Yogesh Bhatt is Fund Manager, Prudential ICICI Mutual Fund)