Volatility aids arbitrage

CATEGORY WATCH: ARBITRAGE FUNDS

While the markets have been crashing around us, there has been one category of mutual funds that have actually generated returns in the green. They are the Arbitrage Funds. Quite often referred to as equity-and-derivative funds, arbitrage funds are an ideal way of earning a reasonable income from equities with the modest amount of risk, Here's how.

The objective of an arbitrage fund is to capitalise on a stock's price difference between the spot market (cash segment) and the derivatives market (futures & options segment). These funds basically generate income by taking advantage of the arbitrage opportunities arising out of the mis-pricing between the two markets (spot and derivative).

Let's illustrate this concept with a hypothetical situation. Let's suppose that the stock of Company XYZ is trading at Rs 500 in the spot market. Simultaneously, the stock is also being traded in the derivatives market where the stock future is priced at Rs 510.

Now, when an arbitrage fund manager sees such a mis-pricing, he sells a contract of the XYZ stock future at Rs 510 and buys an equivalent number of shares at Rs 500 from the cash segment. In this way, he earns a risk-free profit of Rs 10 per share (minus relevant transaction costs). The best part about such profit earnings is that they can come irrespective of the overall market movement.

Furthermore, on the settlement day of the derivatives segment, the stock prices in both the markets tend to coincide. So, the fund manager will reverse his transaction