What is Arbitrage fund ?

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What Is Arbitrage?

All You Need To Know About Arbitrage Funds

Arbitrage involves the simultaneous purchase and sale transactions of an asset in two different markets (i.e., cash and futures markets) to profit from inefficiencies in the prices across these markets. And the funds that work on this principle are called Arbitrage Funds. Although the mechanism may sound complex to a layman, it’s pretty straightforward once you understand the cash market and futures market.

Let’s first understand the two markets a bit better.

Cash market

Also known as the spot market, this is the market where transactions are settled on the spot. For instance, think of the secondary equity markets. When you buy shares on the NSE, your account is debited with the funds, and your transaction is settled on the spot.

Futures Market

A futures market, as the name suggests, is a market where you can buy the right to buy or sell an asset at a predetermined price on a future date. The prices of an asset in the futures market may be higher or lower than in the spot market, and this difference is what an arbitrage trade intends to capitalize on.

Arbitrage Funds: How Do They Work?

Arbitrage funds are mutual funds that aim to generate profit from price differential in the derivatives and cash (or spot) market through simultaneous buy & sell transactions in cash and futures markets. For instance, an arbitrage fund could buy an asset in today’s cash market and simultaneously sell it in the futures market at a higher price, thereby locking its gain right away.

Before diving deeper, let’s understand how an arbitrage transaction goes and why volatility is such a good friend of these funds.

For instance, let’s say Fund X purchased 5,000 shares of company A at Rs. 500 per share (i.e., Rs. 25,00,000 in total) and simultaneously sold 5,000 shares in the futures market at Rs. 505. Effectively, the fund manager has locked in a gain of Rs. 25,000 (₹5 x 5,000 shares) on the transaction. If all goes well, the fund will pocket ₹25,000 when the futures contract expires.

However, the market sentiment turns sour, and prices plummet. The shares now trade at Rs. 485 in the spot market and Rs. 480 in the futures market. While this could have been a problem for an equity fund, an arbitrage fund will sail through this setback.

At this point, the fund is losing Rs. 15 (Rs. 500 – Rs. 485) per share in the spot market but is gaining Rs. 25 per share in the futures market (Rs. 505 – Rs. 480). This means the fund’s total profit from the transaction increases to Rs. 10 per share (₹25 – ₹15) or Rs. 50,000 (₹10 x 5,000 shares).

Fund X generated a 2% return on one trade (₹50,000 ÷ ₹25,00,000). In reality, arbitrage funds generate much less on a single trade.

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