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Thursday, November 26, 2009

Arbitrage


What is arbitrage?

Arbitrage is an investment strategy aimed at capturing the price differential between two or more markets to earn a risk-free profit. To execute an arbitrage deal, one has to simultaneously enter into deals in two markets where the price differential exists.

For example, one can buy shares of Company ABC in cash market at Rs 100 a piece and at the same time sell a future contract of an equal number of shares at Rs 105. This helps to catch the price differential of Rs 5 per share. By the end of the expiry of the contract, prices in cash and futures market converge, offering a risk-free profit.

Conversely, one may sell in cash market and buy in futures, if the price in the cash market is higher than the futures market, provided there is an efficient security lending arrangement.

Can money be made in this manner?

There are many who identify arbitrage opportunities across asset classes and markets. These are called arbitrageurs. Continuous tracking of markets and availability of good amount of cash are must to carry out the role of an arbitrageur to make a decent size of money.

Narrow spreads also limit the rate of return. This makes life difficult for an individual with limited resources.

How do retail investors participate?

Mutual funds come to the rescue of those who intend to take the arbitrage route but lack the expertise. The schemes here aim 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 Rs 5,000. The ideal time horizon of an investment ranges between one and two years. The expected rate of return can be slightly above that of one offered by bank fixed deposits of a similar tenure.

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