Arbitrage is a practice to capture the price differential between two or more markets to earn a risk-free profit. One has to simultaneously enter into deals in two markets where there is a price differential.
For example, one 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 the cash and futures market converge, offering a risk-free profit. As the prices converge, the trader reverses the positions in both the markets — ie, sells in the cash market and buys in the futures markets—and pockets the price differential captured at the time of initiating the trade.
On the other hand, one may sell in the 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, due to lack of a cost-efficient security lending mechanism, market participants prefer to buy in the cash market and sell in futures to realise risk-free profits from equities.
Arbitrageurs — a class of market participants — identify arbitrage opportunities across asset classes and across markets. The continuous tracking of markets and availability of good amount of cash are must to carry out an arbitrage business that offers scope for making decent money. Narrow price differentials or spreads also limit the rate of return. This makes the 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. The schemes hereaim 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 of an investment in these funds ranges from one year to two years. The expected rate of return can be slightly above that from bank fixed deposits of similar tenures.
