What is Arbitrage fund?

Question

What is Arbitrage fund?

Answer 1

A kind of hedged investment meant to capture slight differences in price; when there is a difference in the price of something on two different markets the arbitrageur simultaneously buys at the lower price and sells at the higher price.

Answer 2

The arbitrage fund is taking advantage of the mispricing between the cash and the derivatives market. Suppose the stock price of XYZ Ltd. is quoting at Rs. 600. Let's say the stock is also traded in derivatives segment, where its future price is Rs. 610. In such a case, one can make a risk-free profit by selling a futures contract of XYZ Ltd. at Rs. 610 and buy an equivalent number of shares in the equity market at Rs. 600.

Now when settlement day arrives, it wouldn’t matter which direction the stock price of XYZ Ltd. has taken in the interim. In other words, it is irrelevant whether the share price of XYZ Ltd. has risen or fallen, one would still make the same amount of money. This happens because on the date of expiry (settlement date) the price of the equity shares and their stock futures will tend to coincide.

Yes, it does sound like a very simple and effective way of making money in the market. After all, the problem that most investors have with entering into the equity market is the lack of assured risk free returns. And now here is a product that gives you exactly that. However, if only life were indeed that simple.

The first hurdle is the presence of arbitrage opportunities. In a given period of time, the market may or may not provide any meaningful arbitrage opportunities. And as explained above, it is these arbitrage opportunities that hold the key to the amount of money the fund will earn. No doubt, the fund management team will have to be extra vigilant in identifying such opportunities.

Secondly, there is the issue of costs. Each transaction in the stock market involves payment of brokerage and security transaction tax (STT). These costs directly dilute the earnings. Each leg of the entire transaction i.e. buying stock, selling future, selling stock and buying futures will entail the payment of these costs. Therefore, it again comes down to the presence of the arbitrage opportunity and it being meaningful enough i.e., after the payment of the expenses, the left over profit if any, should be material enough to make the transaction worth entering into.

Answer 3

Arbitrage funds are often promoted by fund houses as "risk-free" investments. They are made to appear as if they can only post positive returns; a negative return is not possible. Put simply, these funds are projected as a sure shot way of earning "risk-free" returns. Nothing can be further from the truth; arbitrage funds do have their own share of risks and the same should be taken into consideration before investing in them.

As a strategy, arbitrage involves simultaneous purchase and sale of identical or equivalent instruments from two or more markets in order to benefit from a discrepancy in their prices. What leads (or rather misleads) everyone to believe that arbitrage funds are risk-free is that, in arbitrage strategies, both the buying and selling transactions exactly offset each other (supposedly), thus making it immune to the market movements. That is, regardless of stock market fluctuations, the fund will not get impacted. The profit in arbitrage strategy is the difference between the prices of the instrument in different markets (like cash and derivative markets for instance).

The truth however is that arbitrage funds are not risk-free. Where does the risk lie? Well, factors like the availability of arbitrage opportunities, their 'perfect' execution and also the liquidity in the stock/cash and futures segments are some of the factors that contribute to the uncertainty, and therefore risk, with respect to this investment avenue.

Have a look at the following links to get more info on the topic

http://in.rediff.com/money/2006/oct/11mc...

http://in.mutualfunds.yahoo.com/070629/9...