The Hindu Business Line : Bananas, stocks and arbitrage

Suppose bananas are priced at Rs 50 a dozen in a wholesale market. You notice that the same quality retails for Rs 55 a dozen in your neighbourhood. If you buy bananas at Rs 50 and sell at Rs 55, you are taking advantage of the price differential after adjusting for the transportation cost.

Exploiting such a price differential in the financial markets is referred to as arbitrage. But note that the academic definition states that arbitrage is essentially a transaction that carries no risk.

Suppose BHEL trades for Rs 575 on the NSE and at Rs 580 on the BSE. You would buy shares on the BSE and sell on the NSE and pocket the difference after paying brokerage. If you do the transactions simultaneously, you do not run the risk of the prices moving against you. That is conventional arbitrage.

Arbitrage plays an important role in valuing assets. Suppose the spot price of Reliance Industries is Rs 550. What will be the theoretical price of Reliance in the futures market? If you buy 100 shares of Reliance, you pay Rs 55,000 after your broker executes the buy order.

You do not pay the entire amount if you buy a futures contract. You can, therefore, invest the money and earn interest on it.

Assume that the interest earned on Rs 550 for one month is Rs 2. The theoretical futures prices will be then set at Rs 552. This is the spot price plus the interest earned on the spot price till the maturity of the futures contract. At this price, there is no arbitrage opportunity between the spot price and futures.

In financial economics, this is called the no-arbitrate condition.

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