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What are Arbitrage Funds?

What are Arbitrage Funds?

Published on 14 December 2021 Views 5 Comments 0

1. What is Arbitrage?

Before understanding the concept of these funds, we should know the definition of the word ‘Arbitrage’. Arbitrage is the simultaneous buying and selling of an asset in different markets to benefit from the price difference of the assets in those markets.

It is a trade that produces risk free profits by exploiting the price difference of the same financial instrument on different markets or in different forms. Arbitrage exists due to market inefficiencies.

Example: Suppose Tata Motors stock is trading at ₹500 on the BSE while, at the same moment, it is trading for Rs.500.1 on the NSE. A trader can buy the stock on the BSE and immediately sell the same shares on the NSE, earning a riskless profit of 10 paise per share. This risk-free profit is arbitrage.



2. What is Arbitrage Fund?

In financial markets, these arbitrage opportunities may exist due to price difference between two indices, spot and future prices and currency exchanges. Arbitrage Funds majorly take the benefit of difference in spot and future price.

They are equity mutual fund and hybrid nature as small portion is allocated to debt. Market volatility gives lot of arbitrage opportunities and so arbitrage fund performs best in volatile market.

In arbitrage fund we are not investing in fundamentals of an equity, we are just to exploit the price difference of a stock in various market hence it is considered risk free and compared with liquid fund. Both the liquid and arbitrage fund has given return around 8% in past.

3. Key Features of Arbitrage Funds-

    1. Arbitrage Funds are safe and carry little risk. Fund manager reduces the risk of equity by hedging against derivatives. Their returns are not impacted by Market volatility.

    2. More the volatility in the market, more mis-pricing opportunities and hence better performance of Arbitrage Funds.

    3. Since major portion of their portfolio is invested in Equity, they are considered as Equity funds from tax perspective.

    4. Though their risk profile is similar to Debt Funds, they cannot be considered alternate to Debt Funds as they are minimally impacted by interest rate changes.

    5. The returns on these funds are mainly dependent on the fund manager’s ability to spot arbitrage opportunities. These opportunities are limited in the market and lately more arbitrage funds have come up in the market. Therefore, with more funds i.e. more money chasing these arbitrage opportunities, the returns can reduce.

Example: Kotak Equity Arbitrage Fund, Reliance Arbitrage Fund

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