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November 23, 2018

Arbitrage Funds: Leveraging volatility to deliver returns

Volatility and risks are an inherent part of investing – and are the major reasons why investors often shy away from the equity markets. But what if one could leverage the inherent volatility of the stock market and turn it into an investment opportunity while hedging the risks at the same time? Arbitrage funds, a type of equity-oriented hybrid funds, do just that by taking advantage of the pricing differential or arbitrage between stocks traded in the cash and derivatives segments to generate returns.

 

This article looks at how arbitrage funds profit from volatility – they have delivered positive, if moderate, returns over the past one year at a time when most other equity fund categories have slipped into the red -- and how their tax treatment makes them more attractive.

 

Given the growing importance of arbitrage funds, CRISIL has added the category in its CRISIL mutual fund rankings from September 2018. Investors can refer to the rankings to identify the top performers in the category at https://www.crisil.com

 

What are arbitrage funds?

 

Arbitrage is nothing but the purchase and sale of an asset at the same time in order to benefit from the price differential that arises between stock prices in the cash and derivatives (futures) segment. Arbitrage funds, thus, are premised to take advantage of just such arbitrage opportunities by locking in the spreads that are available between the cash and futures market.

 

For example, suppose the stock price of XYZ Ltd is Rs. 600 in the cash market and its futures price (in the derivatives segment) is Rs. 620. In such a scenario, an arbitrage fund can earn by selling a futures contract of XYZ Ltd. at Rs. 620 and buy an equivalent number of shares in the cash market at Rs. 600. On the settlement date, the company’s stock price and futures price would converge and the transaction can be reversed. Thus, the fund can make a clean profit from this arbitrage opportunity.