ARBITRAGE is a practice to capture the price differential between two or more markets to earn a risk-free profit. You have to simultaneously enter into deals in two markets where the price differential exists. For example, you can buy shares of Company XYZ in the cash market at 100 a piece and at the same time sell a future contract of equal number of shares at 105. This allows the individual to catch the price differential of 5 per share. By the end of the expiry of the futures contract, the prices in cash and futures market converge, offering a risk free profit. As the prices converge, traders reverse the positions in both markets and pocket the price differential captured at the time of initiating the trade.
In contrast, you may sell in cash market and buy in futures, if the price in the cash market is higher than the futures market. This requires an efficient security-lending arrangement. In India, since we do not have a cost efficient security lending program, market participants prefer to buy in the cash market and sell in futures to realise risk-free profits from equities.
There are many market participants who identify arbitrage opportunities across asset classes and across markets. These are called arbitrageurs. Continuous tracking of markets and availability of good amount of cash are a must to carry out the role of an arbitrageur to make substantial profits. Narrow price differentials or spreads also limit the rate of return. This makes life difficult for an individual with limited resources.
Mutual funds come to the rescue of those who intend to take the arbitrage route but lack the expertise. These schemes aim to make risk-free profits, by capturing the price differentials across markets arising out of the inefficiencies of the markets. You can invest in such funds with a minimum of 5,000. The ideal time horizon for investing in these funds is between one to two years. The expected rate of return can be slightly above that offered by the bank fixed deposits of similar tenure.
