The Hindu Business Line : Arbitrage opportunity

Arbitrage is the strategy by which an investor can earn risk-free profits. It is the simultaneous buying and selling of a security to take advantage of the price differential. The price differential helps the investor/trader make profits by buying the security where it is cheaper and shorting (selling) it where it is traded at a higher price.

For example, assume shares of Andhra Bank are trading at Rs 55 in BSE and Rs 56.5 in NSE. One might buy share of Andhra Bank in BSE at Rs55 each and sell them for Rs 56.5 each in NSE, earning a profit of Rs 1.50.

Arbitrage opportunities reduce with the quicker dissemination of information. While there were far more areas in which to execute arbitrage trades earlier, these opportunities are getting fewer in the Indian markets now.

Speed is vital

With the increase in market volatility, price differentials between markets are accentuated since traders have no time to notice or correct these differences. The number of arbitrage opportunities increases in such periods. However, speed in executing trades is important for the success of arbitrage trades since execution delays can result in reducing or even wiping out the profits.

Arbitrage trades can be done between cash and derivative markets, between the same security listed on different exchanges in India. The price difference between the stock price on domestic exchanges and that of their ADRs or GDRs can also be exploited by arbitrageurs. Opportunities also exist during the mergers, takeovers and buybacks when investors can sell the future of the acquiring company and buy the target company.

Low-risk advantage

Assume Reliance October futures trades at Rs 1,976 and the spot price is Rs 1,906. An investor can buy the underlying Reliance share for Rs 1,906 and short the Reliance October future at Rs 1976.

If Reliance trades at Rs 1950 on the settlement day, the price of the future converges towards this spot price. Therefore, if the investor sells the underlying at Rs 1,950 and buys the shorted future at 1,950 he will be making a profit of Rs 70.

Even if the price of Reliance spot is Rs 1,990 on the settlement day, the investor will be making a profit of Rs 70 on the arbitrage.

With the resumption of short-selling in cash in Indian equities, arbitrage is also possible on reverse cash and carry ( buying futures and selling in spot market). This transaction should, however, be squared within seven days since that is the time limit for short-selling in cash. Interest rate arbitrage is also available for global investors, where in they borrow at lower rates in their respective country and lend at higher rate in some other country. But this arbitrage opportunity is offset by the forward premia on the currency. That is, if you get a loan for 4 per cent in the US and you lend it in India at 12 per cent, the gap is offset as the forward premium on the dollar will nullify the arbitrage opportunity.

There are also arbitrage funds which specialise in spotting these opportunities and give better returns in this market.

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