With the recent reports that traders would be cashing in on the difference between (in a way arbitrage) the open offer of Ranbaxy (Rs 737 due September) and its spot price (around Rs 505 as of August 8, 2008), it seems that the role of arbitrage is still not pronounced irrelevant by equity players. In fact, it proves that arbitrage can be one of the strategies useful in the market situation that you can employ. Here is an analysis of keys things involved in an arbitrage strategy and things you should keep in mind while arbitraging. Though ideally construed to be leveraging between the price difference in the spot and the F&O segment, it is actually the difference in the price of a security in any market (in spot as well, BSE and NSE).
Why arbitrage
Pricing in derivatives is a sole outcome of arbitrage. If the relationship between the price of the spot and the price of futures is violated, then an arbitrage opportunity is available, and when people exploit this opportunity, the price goes back to its economic value. Experts believe that, arbitrage is one of the strategies that bring in efficiency in the markets. It is believed that the market efficiency of the derivatives market is inversely proportional to the transaction costs faced by arbitrageurs in that market. When arbitrage is effective, market efficiency is obtained, which improves the attractiveness of the derivatives from the viewpoint of users such as hedgers or speculators. The arbitrager is an important intermediary that helps in a price discovery mechanism in all markets, be it equity, money forex or derivatives. There are three important participants that are important in a cash market: the speculator, arbitrager and an investor. In a futures market, the investor is replaced by a hedger.
What it involves
The arbitrager is one who plays the role of balancing the price differences across markets. The markets may be two exchanges trading in the same product or two segments such as cash and derivatives or across international markets and local markets. The arbitrager continuously tracks prices across the chosen segment.
An arbitrager has money power at his disposal. He takes deliveries in a particular market segment and is able to give deliveries in another market segment. There is a time gap between giving and taking deliveries. He holds the stock for this time and earns an interest on the funds invested, which comes by way of price differential between buy and sell rates. The arbitrager has a particular interest return as his target. He does not have any open positions and all his purchases or sells in a particular market segment have a counter position in another market segment. At the net level his position is always zero. This is how the arbitrager earns a risk free return.
Arbitrageurs do not always wait for the expiry of the contract or the settlement of the transaction. They may reverse the position before the actual settlement date even if they have to compromise on some percentage of the price difference earned by them. A lesser return is acceptable if it is earned with a smaller or no investment. All decisions are taken with reference to a benchmark-targeted return.
To give an example of an arbitrage transaction, assume that the arbitrager has Rs 10 lakh available for doing arbitrage activity. His targeted return is say 18% pa, which works to about 1.5% pm. We will take a simple transaction where he does just one trade to earn the return. If some share is quoting at Rs 1,000 in one cash market he will look for opportunity to buy at Rs 1,000 and sell at Rs 1,015 or more in another cash market simultaneously. These markets must have different settlement dates, otherwise in a current rolling settlement situation it is not possible to give and receive delivery since both happen on the same day.
The arbitrage that happens between the cash and derivative segment follows this format. Shares are purchased in the cash market; and sold in the futures market. Delivery of the shares is received in the rolling settlement. Since deliveries are not permitted in a futures market, a reversal opportunity is looked for before the expiry of the contract, otherwise the arbitrager will be left with the delivery of shares. Hence, if he gained say Rs 25 per share on the first leg, he will reverse the trade upto a loss of Rs 10 in order to achieve his benchmark return of Rs 15.
What you should take note of
The returns are not often as good as it seems but opportunities are many. You also have to deduct from this the cost of brokerage, securities transaction tax, stock exchange charges and stamp duty. Hence it becomes unviable for an investor unless the transaction costs are very low. The price difference is only for a few minutes or seconds. Hence it must be captured instantly through a speedy trading system.
It should not so happen that one transaction is done and the other one does not go through i.e. if the arbitrager buys and is unable to sell and the market falls, then instead of making a profit he will end up with a loss.
However, there are automated trading programs used in order to release both orders so that both the prices are captured simultaneously. A small investor may not always be able to capture small differences in prices. They are not constantly in front of the trading screen nor do they have sophisticated trading systems to execute the orders. They are often linked to the internet or a network connection that is not a direct feed into the stock exchange system i.e. BOLT or NEAT.
Streaming quotes on online trading is the closest that is available for such trading. The best strategy is to look for differences in shares prices of stocks that you already have. Hence delivery is not a problem. Otherwise it is a volume game. Small returns over thousands of transactions is the name of the game.