- You can buy 100 shares of Reliance Industries on NSE. Your total cost price will be Rs 2,08,365.
- Almost immediately, you sell these 100 shares on BSE at Rs 2086.20 per share. Your sale price is Rs 2,08,620.
- You made a risk-free profit of Rs 255 in a matter of seconds!
What is Arbitrage?Arbitrage is the simultaneous buying and selling of the same asset in different markets in order to profit from tiny price differences. In the above definition, note that the asset remains the same. Only the market changes. In our example, the asset was the same i.e. shares of Reliance Industries. We only changed the market from NSE to BSE. At any given point of time, there are multiple arbitrage opportunities in the market. Let us look at the below table. Before you start searching for such stocks, here are some things you need to know about arbitrage opportunities:
- Arbitrage opportunities vanishes in seconds. So you need to make quick decisions.
- Not all stocks provide arbitrage opportunities. In the above example, there is no arbitrage opportunity in TATA Motors Ltd. Hence, it is important to select stocks which have substantial price difference.
- Arbitrage opportunities come with minimal price differences. Hence to make higher profits you will have to buy more shares.
- You should only arbitrage in stocks with high volumes otherwise you’ll be stuck with no exit route.
More Shares = More Profits from Arbitrage Opportunities
|Share||Share Price on NSE||Share Price on BSE||Difference between share prices||Profit on 10 shares||Profit on 100 shares||Profit on 1,000 shares|
|HDFC Bank Ltd||1,498||1,497||1||8||75||750|
|Bajaj Finserv Ltd||9,434||9,454||20||202||2,020||20,200|
|TATA Steel Ltd||741||741||1||5||50||500|
|TATA Motors Ltd||310||309||0||1||10||100|
What are Arbitrage Funds? – Definition of Arbitrage FundsArbitrage fund is a type of hybrid mutual fund. It invests in both equity and debt instruments. The Securities and Exchange Board of India (SEBI) defines arbitrage funds as open-ended mutual fund scheme with minimum 65% of assets in equity and equity related instruments. But what does ‘Equity & Equity related instruments’ mean? Equity refers to stocks. Equity related instruments is futures and options (F&O). Unlike other mutual funds, your arbitrage fund also participates in the F&O segment. We all know that the price of a futures contract is derived from the price of the underlying asset in the spot market. Normally, futures price is higher than spot price. Read our detailed article on futures contract here. Both spot price and futures price are different but converge on expiry.
|Share||Spot Price (NSE)||Futures Price (NSE)||Difference between spot & futures price||Profit in Futures Market Per Lot|
|HDFC Bank Ltd||1,498||1,502||4||2,172|
|Bajaj Finserv Ltd||9,395||9,417||23||2,837|
|TATA Steel Ltd||740||741||1||1,700|
|TATA Motors Ltd||307||308||1||4,275|
- Buying 1 lot of Bajaj Finserv futures and making Rs 2,837!
How Does Arbitrage Funds Work? – Working of Arbitrage Mutual FundsAn arbitrage fund works in two phases –
- Purchase or sale in cash market
- Long or short in futures market
How an arbitrage fund works when the fund manager expects share price to increase.
How an arbitrage fund works when the fund manager expects share price to fall.
Fund Manager – Captain of Arbitrage FundsWhile all fund managers are equally important, fund manager of an arbitrage fund plays a critical role in the fund’s success. He is responsible for discovering arbitrage opportunities and then quickly taking positions in cash and futures market. Additionally arbitrage fund manager also has to ensure to invest in high quality debt instruments to balance risk from F&O segment.
Should you Invest in Arbitrage Funds? - Advantages of Arbitrage Funds1. Almost Zero risk: Arbitrage funds engage in buying and selling of the same asset simultaneously. So, they have no long-term risks. Arbitrage funds do not care about long-term prospects of the stock. They only exploit the price difference between the markets to make risk-free short term profits. 2. Balanced Portfolio: Arbitrage funds are balanced funds. They invest 30-35% of their corpus in debt instruments. They invest in zero coupon bonds, treasury bills, AAA rated bonds etc. These instruments carry zero risk. Hence arbitrage funds are able to balance equity risk using debt instruments. 3. Equity Taxation: Arbitrage funds are considered as an alternative to liquid funds. Since they also carry zero risk. But liquid mutual funds follow debt taxation. So you must hold your liquid fund for 3 years to qualify for long term capital gains tax (LTCG). This is not the case with arbitrage funds. You qualify for LTCG taxation if you hold the fund for more than 12 months.
Disadvantages of Arbitrage Funds1. Average Performance during stable market: Arbitrage opportunities are created during volatile markets. During stable markets, arbitrage funds tend to perform poorly. In such cases, the fund may increase its allocation to bonds, which reduces the overall portfolio returns. 2. Mediocre Returns in ‘Liquid’ fund category: Arbitrage funds are considered to be an alternative to liquid and ultra-short term funds. However their long term performance is worse in comparison. 3. High Churning Ratio & Expense Ratio: An arbitrage fund is continuously buying and selling stocks. Hence they have a high churn ratio. A high churning ratio directly increases the expense ratio. For example:
- The churn or turnover ratio of Edelweiss Arbitrage Fund is 357%! Its expense ratio is 1.39%.
- The turnover of Nippon India Arbitrage Fund is 1298%!
How are Arbitrage Funds Taxed?Arbitrage Funds have a holding period of 12 months.
- If you redeem from arbitrage funds before 12 months, a short term capital gains tax of 15% is applicable.
- If you redeem from arbitrage funds after 12 months, you pay long term capital gains tax at 10% only if your gains exceed Rs 1 Lakh.