Arbitrage Funds in India

What are Arbitrage Funds?

Arbitrage Funds are when you purchase low and afterward sell high. More specifically, you buy a good item of low price in a market and resell the same good in a market where it is priced higher. The effect of arbitrage is to bring prices together in those two markets, so it becomes more difficult for firms to discriminate.

The word arbitrage sounds exceptionally fancy, but it’s really a very simple thought. It’s really just taking advantage of differences in cost on essentially the same thing to make risk-free profit. Let’s say in one part of town there’s some type of a market. Let’s say it’s a market for apples. And let’s say in that market, apples sell for-- just make up some price. Let’s say that apple’s in that market, sell for $1 per apple.  And let’s say in another part of town, you have another market. Another market’s literally a fruit market. And in that other part of town, apples sell for $1.50 an apple. And we are going to assume that these apples are completely identical apples. How can you take advantage of this price difference on these same things to earn a risk-free profit? Well ideally, you would want to sell apples in the more expensive market where you could get $1.50 per apple. And you would want to buy apples in the less expensive market where you can get them for $1 per apple. And that’s exactly what you would do. You would go do this market over here, you would buy apples. Let’s say you buy 20 apples for $20. And then you would go maybe ride your bicycle a couple of blocks to that other market over there. And you would sell your 20 apples. So this is buy 20 apples for $20. And then you would sell those 20 apples for $30. And so you would make an immediate risk-free profit of $10. You are buying for 20, selling at 30. And you could just keep doing that over and over again. And on every trip as many apples as your bicycle could carry you will just continue to make money. And so this is what arbitrage is. And just imagine a side effect. If someone did this enough, then what would do is it would increase the supply of apples here. So supply would increase in this market. And on this market, the demand would increase because there’s someone who just keeps buying from this market and selling into that market. So what’s eventually going to happen when demand increases, the price will go up in this market. And when the supply increases in this market, the price will go down. So in theory, the more you do this, the more that you are going to make these prices come closer to each other. And eventually, you won’t be able to make any profit at all. But while there’s this discrepancy, you have an opportunity for arbitrage.

Arbitrage Fund

So an arbitrage fund is an open-ended equity scheme which uses the arbitrage strategy of investing. Arbitrage is nothing but the price difference between the cash and the futures market. Arbitrage Funds can create more and better returns when markets are unstable. The unpredictable markets can create arbitrage opportunities. But, do not invest in Arbitrage funds with a goal to get two fold digit returns. The profits, best case scenario can be in the scope of 5 to 8%.

lets understand this better with some examples:
Example 1: If you have a stock let’s say a)Trading in NSE for Rs.100 and at the same time its trading in BSE for Rs.99, the fund manager will buy it on BSE and sell it in NSE and make a Re.1 profit without taking any risk this is called an arbitrage strategy.

Example 2: Rohan and Sham was a producer of a special plastic material that had uses in both industry and dentistry. This plastic had a variety of substitutes in industry, but very few substitutes in dentistry. Therefore, it was less expensive in industry than in dentistry --85 cents per pound versus $22 per pound. Of course, with a price difference like that, entrepreneurs started to arbitrage -- to buy up the industrial plastic, convert it to the plastic for dentures, and then resell that plastic at the higher price. But before the prices could adjust from arbitrage, Rohan and Sham took drastic measures to prevent arbitrage from happening. Now this prevention of arbitrage is not the norm though. Truth be told,, arbitrage is working in background the scenes to prevent price differentiation in almost all products markets.

Why should one invest in an arbitrage fund, so if you are looking to take less risk and still make a decent return then arbitrage funds are for you, arbitrage funds take advantage of the mispricing between the price and the derivative markets, they simultaneously buy in one place and sell in the second place thus making sure the risk is very minimal.

Who should invest in an arbitrage fund? arbitrage funds are best suited for investors who are looking at taking very low degree of risk and also who want to make sure that there’s not much volatility in their returns, arbitrage funds are best suited anywhere from one month even all the way up to a year from an investors horizon. So now that we know arbitrage funds are a low risk and low volatility investment option.

The Arbitrage support classification normal returns over the most recent one year was around 5.5% and in the last 2 to 3 years the profits have been around 7%.

The current FD rates for 1 to 2 year are around 6 to 7%. However Arbitrage funds are more tax efficient than FD's. So, if you are wanting to put your money in FD's for short term, you may think about putting money into Arbitrage Funds.

Post a Comment

Please do not enter any spam link in the comment box