What is Arbitrage?
Arbitrage is the process where an investor or a trader spots an opportunity to make returns using the price difference between the spot and the futures market.
Example: TCS is trading in the spot market at Rs. 3000 and the futures contract of TCS is trading at Rs. 3050. In such a scenario, a trader can buy shares of TCS in the spot market and sell an equal number of TCS futures.
As the prices of spot and futures converge on expiry, the trader can make a return of Rs. 50 per share.
Types of Arbitrage Opportunities:
What is an Arbitrage fund?
- It is a type of hybrid fund (which invests in more than one asset class i.e. equity, debt and other asset classes) that focuses on generating returns by focusing on arbitrage opportunities.
Key things to know about Arbitrage funds
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As arbitrage funds focus on generating profits from the price differences between two assets, the returns generated by these funds are higher in an environment of higher spreads. Similarly, if spreads are lower, the returns too will be on the lower side.
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A high-interest rate environment usually aids in higher returns as yields of the Fixed Income portion of the funds go up.
How does taxation work?
Arbitrage funds are treated as equity funds for taxation. Investments held for less than one year are taxed under short-term capital gains (STCG) at a rate of 15%. Investments held for more than one year are considered long-term capital gains (LTCG). LTCG over Rs.1 lakh a year is taxed at the rate of 10% without the benefit of indexation.
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As the strategy is generally market neutral and is based on arbitrage, the risk is extremely low and is suitable for Investors who are risk averse and are looking for alternatives to liquid and bank deposits
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Investors in higher tax brackets who want to take advantage of equity taxation.
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As many investors believe, Arbitrage funds are not risk-free. Thanks to the debt component, there is an element of risk.
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Returns hover in the range of about 5-7%, which can get wiped out in a single shot if things go wrong.
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Recovery takes time. Hence it is prudent to have a long-term investment horizon while investing in an arbitrage fund.
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The good part of an arbitrage fund though, is that it behaves as a debt fund but gets taxed as an equity fund. Arbitrage funds tend to outperform in a high-interest rate environment (higher returns in Fixed Income portfolio) and also do well when equity market sentiment is buoyant.
To know more, do check out the Varsity’s chapter on arbitrage funds :