Decoding Arbitrage Funds

May 29, 2015 Arbitrage Trading 2 min read
Decoding Arbitrage Funds

The term arbitrage maybe quite new to some investors reading this articles, so let me first explain what does the term ‘ Arbitrage’ exactly mean. Arbitrage is taking the advantage of price difference of the same asset in two different markets/segments.

So let’s say Reliance future is online trading at 980 in cash market and 990 in future segment, the arbitrageur will buy the reliance shares in cash segment and sell the same quantity in future segment to take the price mismatch advantage, at the expiry of the future contract the price of both the cash and future segment of same asset coincides, let’s assume 3 expiry possibilities and the payoff for the trade thereby :

Decoding arbitrage funds would help stock traders

Reliance Closing Payoff from Reliance’s Share Payoff for Reliance’s Future Net payoff
800 -180/share +190/share +10/share
1200 +220/share -210/share +10/share
980 0/share +10/share +10/ share

 As you can see from the above example the payoff in any condition whether the stock prices rises, falls or stays stable the trade will get a risk free 10/share profit from the trade.

Now the main reason for the arbitrage difference can be due the inherent stock market sentiments, interest cost, corporate action in the stock etc. One also needs to take care of the online trading costs during the arbitrage trades.

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Why Arbitrage funds are in flavor:

Arbitrage funds which normally gives return in the range of 7-11%, year depending on the stock market volatility, investors have turned up to the arbitrage funds as a proxy for debt funds, as the post tax returns in Arbitrage funds, specially for a 30% bracket individual are more attractive then the Debt mutual fund only if held for a year or more

So there is a huge buzz on the arbitrage funds especially since this year’s budget, and we have seen huge fund flows into this category

For an investor if you are a conservative investor or think the Equity markets currently are overvalued, this is a good investment option for a defensive investor

Also Read : Fundamentals, Technicals or Speculation? What do you do?

Hybrid Arbitrage funds

A new product in the arbitrage fund family has taken birth which can be termed as a proxy or hybrid Arbitrage funds, these funds are basically a mix of equity ,debt and arbitrage opportunities, where around 30% portion is invested in direct equity, 40% in Arbitrage opportunities ( which again is categorized as equity investments from tax perspective) and rest in Debt funds, this in turn gives the returns almost equal or 1-4% more than the normal debt funds, but the tax treatment is done same as the Equity mutual funds, giving the advantage of Equity taxation to the Debt fund investors

Arbitrage funds and financial planning

From the financial planning perspective the Arbitrage fund can play a fantastic balancing role in an investors portfolio, which can be replaced by the Debt Funds and the taxation can enjoyed of an stock market investments

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