Arbitrage funds
Concept of arbitrage
Arbitrage refers to earning profit from temporary price differences in the same asset across:
Two different exchanges (e.g., NSE vs BSE)
Two different markets (spot vs futures)
It involves:
Buying at a lower price
Selling at a higher price
Executing both transactions almost simultaneously
Since trades are executed together, arbitrage does not depend on predicting market direction.
What are arbitrage funds?
Arbitrage funds are a category of hybrid mutual funds that attempt to generate returns from such price mismatches.
According to the Securities and Exchange Board of India (SEBI):
Arbitrage funds are classified as equity-oriented funds.
They must maintain at least 65% gross exposure to equities or equity-related instruments.
Surplus funds are parked in short-term debt or money market instruments.
Thus, although treated as equity funds for taxation, their risk-return profile resembles a low-volatility product.
How arbitrage funds operate
(a) Cash–Futures Arbitrage
Buy stock in the spot (cash) market.
Sell the corresponding futures contract at a higher price.
Profit = Spread between spot and futures price (minus costs).
(b) Inter-exchange Arbitrage
Buy stock on National Stock Exchange (NSE) if cheaper.
Sell simultaneously on Bombay Stock Exchange (BSE) if costlier.
By executing multiple small trades, fund managers aim to generate steady returns.
Why volatility matters
Volatility increases:
Price fluctuations
Temporary mismatches between spot and futures prices
Short-lived spreads across exchanges
In calm markets:
Price gaps are smaller
Opportunities vanish quickly
Returns may be modest
Hence, arbitrage funds often perform better in volatile phases, as spreads widen briefly.
Risk profile
Although considered relatively low-risk, arbitrage funds are not risk-free.
Risks include:
Narrow or absent spreads
Execution risk (slippage)
Liquidity constraints
Transaction costs
Temporary mark-to-market fluctuations
They are designed for capital preservation with moderate returns, not aggressive growth.
Returns and suitability
Historically:
Long-running arbitrage funds have delivered about 6–7% annualised returns on average.
Comparable to Fixed Deposits (FDs) or Recurring Deposits (RDs).
Advantages over FDs:
Market-linked flexibility
Easy redemption
No premature withdrawal penalties (generally)
Equity taxation benefit (if holding period conditions are met)
Prelims Practice MCQs
Q. With reference to arbitrage, consider the following statements:
Arbitrage involves buying and selling the same asset simultaneously in different markets to profit from price differences.
Arbitrage depends on predicting whether the market will be bullish or bearish.
Arbitrage opportunities generally arise due to temporary market inefficiencies.
Which of the statements given above is/are correct?
A. 1 only
B. 1 and 3 only
C. 2 and 3 only
D. 1, 2 and 3
Answer: B
Explanation:
Statement 1 is correct: Arbitrage involves simultaneous buying and selling to capture price spreads.
Statement 2 is incorrect: Arbitrage does not rely on market direction prediction.
Statement 3 is correct: Arbitrage arises due to temporary inefficiencies or mismatches.
Q. Arbitrage funds are classified by the Securities and Exchange Board of India as:
A. Pure debt funds
B. Commodity funds
C. Equity-oriented hybrid funds
D. Pension funds
Answer: C
Explanation:
SEBI classifies arbitrage funds as equity-oriented funds, provided they maintain at least 65% gross exposure to equities or equity-related instruments.