How Does Arbitrage Fund Work?

Arbitrage funds are a type of mutual funds that creates profits for the investors through the differential prices of the equities in the market derivatives by leveraging the market volatility. Typically, in an arbitrage fund, the trader buys securities from the stock market and sells the same in the future market at a higher price and earns profit from such transactions. Since, the arbitrage funds are equity-oriented hybrid funds, they invest in money market and short-term debt instruments.

How Does Arbitrage Funds Work?

As mentioned earlier, the equity Arbitrage fund takes advantage of the difference in the prices of securities in different markets and generates returns. The two markets where arbitrage funds transact primarily are the cash market or the stock market and the futures or the derivatives market.

The stock markets take into account the current value of the securities, whereas the futures market considers the expected prices of the securities in the future. The prices of the securities in the stock market are known as the spot price, and the future date for transactions mentioned in the futures contract is known as the maturity date.

Unlike the spot transactions that take place in the stock market, the securities purchased in the futures market are delivered to the buyer on the maturity date of the contract at the pre-decided rate as specified in the contract. The arbitrage funds earn returns from the difference in pricing of the securities in the stock market and the futures market.

If the market is going high, the fund manager will purchase a certain number of stocks in the stock market and sell the same immediately in the futures market. If the market is going low or is expected to go low in the near future, the arbitrage fund will purchase a futures contract at a lower price and sell the equivalent number of shares in the stock market at the spot price.

Let us understand the working of an Arbitrage with an example:

Let us assume that the equity shares of a company named Delta is valued at Rs. 1,000 in the stock market and in the futures market, it is traded at Rs. 1, 200. In such a case, the fund manager will buy the shares from the cash market at Rs. 1,000 and sort a contract to sell the same at Rs. 1, 200. At the end of the month when the prices of the shares coincide, the fund manager will sell the shares in the futures market, and earn a risk-free profit of Rs. 200 per share.

Final Word

Thus, it is obvious that as compared to other equity-oriented hybrid funds, the arbitrage funds perform better when the market is volatile. But, when the market is less volatile, it is better to invest in the low-risk debt funds.


DISCLAIMER

The information contained herein is generic in nature and is meant for educational purposes only. Nothing here is to be construed as an investment or financial or taxation advice nor to be considered as an invitation or solicitation or advertisement for any financial product. Readers are advised to exercise discretion and should seek independent professional advice prior to making any investment decision in relation to any financial product. Aditya Birla Capital Group is not liable for any decision arising out of the use of this information.