One Minute Guide to Understanding | Arbitrage funds

One Minute Guide to Understanding | Arbitrage funds

What am I

I am a kind of mutual fund and I try to maximize gains by taking advantage of the price difference between two or more markets. Generally, I look at the difference between spot price of a stock and the price of the stock in the derivative segment.

How I make profits

The difference between the prices in the spot and derivative markets gives me an opportunity to make profits. For example, say a stock’s spot price is 100 and the derivative segment price is 110. In such a situation, I sell the stock in the derivative market and buy it in the spot market. My profit will be the difference between derivative market and spot market prices, which in this case will be 10 ( 110- 100). Alternatively, I can also make profit by selling in the spot market and buying in the derivative market if price in the spot market is higher than that in the derivative market.

Risks involved

The only risk that I carry is the lack of arbitrage opportunities and execution of these opportunities. Since, most of the stocks are not allowed to trade in the derivative segment, arbitrage opportunity for me is very limited. (Only 223 stocks out of 2,961 listed on the Bombay Stock Exchange trade on both spot and derivative segment). Also the execution of the limited arbitrage opportunity has to be perfect. Typically, volatile markets, such as now, present more arbitrage opportunities.

Whom I suit

With technological innovations at stock exchanges, it has become easier for fund managers to track arbitrage opportunities. However, due to these innovations, the price differential between spot and derivative segment vanishes very quickly. This has substantially reduced the return these days and my returns remain in single digits. Therefore, I am more suited for investors looking for low risk, low return.

Tax treatment

Since I primarily invest in equity segment, my tax treatment is same as any other equity fund. Accordingly, dividend that investors receive from me will be tax-free. The tax treatment of the gains that investors make will depend upon the time frame of the investment. If gains are realized by investors within one year of investment, they will have to pay a short-term capital gains tax of 16.99% (including surcharge and cess). Gains realized after a year of investment is tax-free.