Index Arbitrage is a trading strategy that seeks to profit from price discrepancies between a stock market index and its corresponding futures contract or between the index and the basket of underlying stocks. The goal of index arbitrage is to exploit temporary mispricing that arises due to supply-demand imbalances, timing differences, or inefficiencies in market valuation.

In simple terms, when the futures price of an index (like the Nifty 50 or Sensex) is higher than its spot index value, traders may sell the futures contract and simultaneously buy the underlying stocks that make up the index. Conversely, if the futures price is lower than the spot value, they may buy the futures contract and sell the corresponding stocks. This process continues until prices converge, eliminating the arbitrage opportunity.

Such strategies are primarily executed by institutional investors and professional traders using automated trading systems, as they require large capital and quick execution. The transactions are usually short-term and depend on small price differences, which can only be profitable when executed in high volumes.

Index arbitrage plays a vital role in maintaining market efficiency. It ensures that futures and spot markets remain aligned, reducing distortions in pricing. However, successful arbitrage requires accounting for factors such as transaction costs, margin requirements, interest rates, and dividend adjustments, all of which can influence profitability.

In India, such trades are carried out through exchanges like the National Stock Exchange (NSE) under strict regulatory supervision by the Securities and Exchange Board of India (SEBI). These regulations aim to prevent manipulation and excessive speculation while ensuring transparency and fairness in market operations.

In essence, Index Arbitrage contributes to smoother price discovery between cash and derivatives markets, promoting equilibrium and improving overall liquidity within the financial system.