What is arbitrage in investment means? How to identify the opportunities?

What is arbitrage in investment means? How to identify the opportunities?

The word arbitrage means a price differential. It could be the price differential between the price on NSE and BSE. This used to exist before but does not exist any longer. It could be the arbitrage between the spot price and the futures price on stocks. This is the most common and popular form of arbitrage. Lastly, there is also the options arbitrage, which is lot more complex and is usually executed through algorithms using high end machines and these are normally done by large institutions and proprietary desks. In this discussion on arbitrage, let us focus purely on cash-futures arbitrage.

Arbitrage in its current form came with the introduction of futures on individual stocks; popularly known as stock futures. Stock futures have a monthly expiry cycle and expire on the last Thursday of every month. At any time there are 3 monthly contracts viz. the near month, mid-month and the far month. But what do we understand by arbitrage. In stock-futures arbitrage you buy in the cash market and sell the same stock in the same quantity in the futures market. We know that the futures price will expire at the same price as the spot price on the F&O expiry day. Therefore, the difference between the spot price and the futures price is the risk-free spread for the arbitrageur.

What is the reason for futures to trade at a premium to spot price?

Futures price pertains to a contract that is 1 month down the line. Hence, there is a cost of carry; also roughly known as the interest cost. In case of commodities, this cost of carry also includes the storage cost, insurance charges etc. So if the annual risk-free rate of interest is 12% then the 1-month futures price must be at a 1% premium to the cash price. Of course, in reality the futures price is determined by a variety of other factors but this is the key factor. Essentially, what you do in arbitrage is to buy in the cash / spot market and sell in the futures market. Thus the gap is locked in and you can unwind and take the profits at the end of the month.

Let us understand with a very simple transaction. You have purchased SBI in spot at Rs.225 and have sold equal to 1 lot in futures at Rs.227. Thus the arbitrage difference of Rs.2 is captured as your assured return. On the expiry date, either ways you realize this return irrespective of the price movement. If the price goes up to Rs.240, you earn Rs.15 on the cash position and lose Rs.13 on the futures position earning Rs.2 net. If price goes down to Rs.210, you lose Rs.15 on the cash position but gain Rs.17 on the short futures. Your net return is still Rs.2. Of course, there are brokerage and statutory charges, which we will not get into for the sake of keeping it simple.

You can realize the profit each month by either unwinding the arbitrage position or by rolling over the short futures position and holding on to the cash market position.

You can even unwind your arbitrage earlier if the spread has come down substantially. Let us understand this with an illustration

The net profit of Rs.7 that he realizes by unwinding can be either seen as the profit on the transaction or the difference in the two spreads. The risk of this strategy is that each month you need to create fresh positions and keep unwinding them. This leads to higher transaction costs, higher statutory costs and also results in short term capital gains on your cash market profits. Hence such a strategy is only workable when profitable opportunities arise due to sudden spurt in volatility in the market; not otherwise.

The more common method is to roll over the short futures position.

You can avoid the hassles of unwinding and creating arbitrage positions each month by holding on to your cash positions and just rolling your futures position to the next month. The cash position remains with you. In this case if the near month futures are at Rs.100 and the next month is at Rs.101.20, then you reverse your position by buying near month and selling next month. Your spread for the month is 1.2% (1.20/100). This is how most of the arbitrageurs prefer to work.

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