What are Arbitrage Funds?
Arbitrage funds make profits through the differences in prices of stocks in the equity (cash) markets and derivatives market or between 2 cash marketsâ€”say, NSE and BSE. An Executive Director of Benchmark Asset Management Co Pvt Ltd says that in the Benchmark Derivative Fund returns are generated by taking advantage in the underlying cash and derivative markets. For instance if the price of Company ABC is quoting at Rs. 100 per share on BSE and Rs. 105 per share on NSE, the arbitrage fund can buy the scrip on BSE and sell on NSE and pocket the difference (i.e. per share) minus brokerage and other charges.
Take this case as an example: Buy Reliance in BSE and sell it in NSE Sounds dumb? Wrong. Thatâ€™s a smart thing to do if the price of Reliance is lower in BSE than in NSE. What you are doing is arbitrage. There are mutual fund schemes that specialize in this investment strategy.
Risks Involved in Arbitrage:
Arbitrage funds come with their own set of risks, the primary ones being.
Â· The arbitrage fund my not be able to successfully close both ends of the arbitrage transaction. For instances, if the fund wants to buy 1 lakh shares on one exchange and sell on the other, while it may be able to successfully buy 1 lakh shares from the exchange, where it wants to buy, it may not be able to sell the entire 1 lakh shares in the exchange where it wants to sell because of lack of buyers in that exchange. A similar situation could arise while doing arbitrage between the cash and futures markets.
Â· While doing arbitrage between 2 cash markets say BSE and NSE, even if the arbitrage fund is able to successfully buy and sell the exact quantity of shares in both markets, it may face delivery problems in the market where it has bought, resulting in lower delivery in the market where it has sold. For instance, if the fund has bought 1 lakh shares of Company ABC in the BSE and sold the same amount in the NSE, if it receives only 90,000 shares in the BSE due to sellers in BSE not being able to deliver; the fund will end up delivering only 90,000shares in NSE. This short delivery will lead to the fund being compelled to buy these shares in auction, most likely at a higher price, leading to either reduction in profits, or probably even a loss in the overall transaction
Arbitrage Funds available:
Presently, there are 3 arbitrage funds available. These are,
1. Benchmark Derivative Fund.
2. JM Equity & Derivative Fund.
3. Prudential ICICI Blended Plan.
While the JM Equity & Derivative Fund and the Prudential ICICI Blended Plan require a minimum investment of Rs. 5,000, the Benchmark Derivative Fund requires a minimum investment of Rs. 2 lakh.
The JM Equity & Derivative Fund and the Benchmark Derivative Fund have given returns of 7.44 percent and 7.24 percent respectively in the 1-year period ending 20 may 2006. In the 6-month ending period ending 20, May 2006 arbitrage funds have given absolute returns in the range of 3-4.5 percent.
With SEBI now allowing mutual funds to participate I the derivatives market, new schemes expected to be launched will be also using derivatives strategies such s the following:
Covered call options:
In this investment strategy, the arbitrage fund will use the stocks it holds to act as a call option writer. A call option writer is one who sells an option to a buyer giving him the right to exercise his option (to buy the underlying stock) or let option lapse before the expiry date (options are valid for specific periods of time such as 1 month, 2 months or 3 months). The option writer (in the case, the arbitrage fund) will earn income in the form of premium received from the call option buyer. For example, letâ€™s assume that an arbitrage fund holds 1 lakh shares of Company ABC and the option premium is Rs. 5 per share. The fund becomes a call option writer for 1lakh shares which it sells to the call option buyer at a premium of Rs 5 lakh (1 lakh shares x Rs. 5 per share). Letâ€™s say the option is valid for 1 month and its expiry date is 30 June 2006. The strike price of the call option is Rs 100 per share of Company ABC. Now, if the price of Company ABC increases to Rs. 120 on or before the expiry date i.e. 30 June 2006, the option buyer will exercise his option i.e. he will buy the shares from the option writer (the arbitrage fund) at Rs.100 and sell the stock in the cash market at Rs 120 to make a profit. In this case, the option writer will pocket the Rs. 5 per share and be compelled to deliver the shares at Rs. 100 as against the market price of Rs. 120. However, if the price of Company ABC falls to Rs. 90 on or before the expiry of the option, the option buyer will let his option lapse and the arbitrage fund will pocket the premium of Rs. 5 per share and continue to hold 1 lakh shares with a lower market value (Rs 90 as against the earlier Rs. 100)
A straddle is an investment strategy where the investor buys a put option (this option gives the holder the right to sell the underlying stock) and a call option (this option gives the holder the right to buy underlying stock) on the same stock with the same expiry date and strike price. This investment strategy works especially well when the investor expects the stock to move significantly either ways from the strike price. Letâ€™s understand how this strategy works with an example. If the arbitrage fund believes that the stock of Company ABC will be volatile in the month of June, it can buy a 1-month call option and a put option on the shares of Company ABC with both options having the same strike priceâ€”say Rs.100 per share Company ABC and same expiry date i.e. 30 June 2006. Letâ€™s assume that the arbitrage fund has paid a premium of Rs. 20 per share for the call option and Rs. 25 per share for the put option. In other words, the arbitrage fund has incurred a cost of Rs. 45 per share and created a price range of Rs. 55 at the lower end and Rs. 145 at the higher end. Now, on or before the expiry date, if the price of Company ABC increases to Rs 160 per share, the arbitrage fund can exercise its call option thereby purchasing the shares of Company ABC at Rs. 100 per share and sell the shares at Rs. 160 per share, booking a profit of Rs. 15 per share (Rs 160 (sale price) â€“Rs. 100 (purchase price)— Rs 45 (premium paid)) However, if the price of Company ABC falls to Rs 45 per share, the arbitrage fund can exercise its put option where it can sell the shares of Company ABC at Rs 100 per share and buy it from the market at Rs 45 per share thereby booking a profit of Rs 10 per share— Rs 100 (sale price)â€”Rs 45 (purchase price)â€”Rs45
A strangle is an investment strategy where the fund holds a call option and a put option with different strike prices but with the same expiry date and the same underlying asset. This strategy offers profits when the price of the underlying asset is volatile. For instance, letâ€™s assume that the stock of Company ABC is quoting at Rs 50 per share. The fund will buy a call option and a put option of Comp=any ABC. The strike price of call option is Rs. 55 per share and is available at a premium of Rs 3 per share. The strike price of the put option is Rs. 45 per share and is available at a premium of Rs. 2.85 per share. In other words, the cost of purchase of the call and put option is Rs. 5.85 per share (Rs.3 + Rs.2.85). If the share price of company ABC trades between Rs. 39.15 and Rs. 60.85 the fund will make a loss to the extent of the premium paid i.e. Rs. 5.85 per share. However, if the share price increases or falls beyond the two ranges, the fund makes money. So, if the share price of Company ABC rises to Rs. 65, the fund can exercise its calls option i.e. buy the share at Rs50 and sell at Rs. 65 and book a gain of Rs 9.15 (Rs 65 (sale price)â€”Rs. 50 (purchase price)â€”Rs. 5.85 (premium)).
Derivative Schemes Expected
The following new derivatives funds are expected to be launched:
1. Prudential ICICI Equity and Derivatives Fund
2. Benchmark Derivatives opportunities Fund.
3. Benchmark Derivatives plus Fund.
How an investor can benefit from arbitrage and derivative funds?
Benefits using arbitrage funds
Arbitrage funds offer an investor another investment opportunity (in addition to equity, debt, gold etc). Besides, these funds donâ€™t face risks of specific asset classes since they simply make gains on the price differences. In other words, the investor does not face risks associated with equity, debt etc. By taking a slightly higher risk, these funds offer better returns than debt funds. Consider adding these funds to your investment portfolio.
Benefits using derivative funds
Derivatives are investment-cum-risk management tools where the price of the underlying asset plays a role in the price of the derivative instrument. An investor again, has available one more investment opportunity, which offers opportunities to create complex investment strategies to make gains.