Making the most of volatility :Arbitrage Funds.

Making the most of volatility
In The current interest rate scenario, the rates seem to have been stable and are not likely to come down, at least in the near future. So it is unlikely that investment in income and debt funds will generate any substantial returns in the short term. Further, the liquidity scenario in the market is also highly volatile, which makes investment in liquid funds a somewhat riskier option. Hence, investors should not try to beat the volatility in their portfolio, but rather, try to exploit the volatility and generate returns from it.

Return from Arbitrage Funds.
Some investors don’t have an appetite for volatility. But some wait for it in a bull market. These are the arbitragers. They have rapidly gaining ground in the investment market by providing a steady performance. Returns from arbitrage funds have been around 8% to 9% in the past few months, which is higher than other funds in the income category. Also, the arbitrage funds fall in the “equity” category and therefore attract lower taxes than liquid funds and other debt-based options like fixed deposits.

The arbitrage opportunity takes place in the spot (cash) and futures markets. Volatile prices and overall excitement-led activity often create strong pricing mismatches between the spot and futures markets.

Let’s take an example to understand how the arbitrage opportunity is exploited to generate profit. Let’s say the share price of NRL Ltd, which is traded in derivatives segment, is Rs 100.And let’s assume that its future price is Rs 110. In such a case, an investor can make a risk-free profit by selling a futures contract of NRL Ltd at Rs 110, and buying an equivalent number of shares in the equity market at Rs 100.

On the settlement day, any change in the stock price would not matter. It is irrelevant whether the share price of NRL Ltd has risen or fallen, as you would still make the same amount of money.

This happens because, on the date of expiry (settlement date), the price of the equity shares and their stock futures will tend to coincide. Now, an investor has to reverse the initial transaction, that is, buy back the contract in the futures market and sell off the equity. So in the entire process, four transactions have taken place—buy stock, sell futures, sell stock, buy futures. In this manner, irrespective of the share price, the investor earns the spread between the purchase price of the equity shares and the sale price of futures contract.

There are several similar opportunities that one comes across when markets are volatile and are in a bull phase. Arbitrage funds will tend to do well in such a scenario. These funds also have the option of parking their money in short-term debt market funds and, in the worst-case scenario, investors will get a return similar to that from a liquid fund. The returns generated by arbitrage funds are nearly comparable to those generated by liquid funds and other debt funds. However, considering the high volatility in the market, investment in arbitrage funds would equip investors to take advantage of the same and generate decent returns. These funds are a good alternative, apart from fixed maturity plans and floating rate schemes, to beat the risks inherent in income schemes.

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