Arbitrage funds: Profiting from price gaps in volatile market Premium

Explore how arbitrage funds leverage price gaps in volatile markets for stable returns without directional market bets.

The next time you place an order to buy or sell a stock through your demat account, just pause and take a moment to glance at its price on the two exchanges – the National Stock Exchange (NSE) and the Bombay Stock Exchange (BSE). You might be surprised to find that the same stock is trading a few paise cheaper on one exchange than the other at that very moment, though not always. Thanks to the constant play of demand and supply.

The price gap is often so negligible that most investors barely notice it or ignore. For seasoned traders, however, such fleeting price mismatches can hint at something more: perhaps an ‘arbitrage’ opportunity, waiting to be captured. What an ordinary investor brushes past as just another volatile phase of the market, a veteran trader may see as a chance to lock in a small, calculated profit.

To put it simply, the term arbitrage refers to the practice of capturing profit from price gaps, in the same asset (such as a stock) in two different markets or financial instruments. It involves a dual transaction of buying at a lower price and selling at a higher price at nearly the same time, thereby taking advantage of the spread between the prices. Since the trades are executed at nearly the same time, the arbitrage strategy does not rely on market predictions.

Arbitrage funds are a category of hybrid mutual funds that seek to generate returns from these short-lived price differences. Market watchdog Securities and Exchange Board of India (SEBI) classifies arbitrage funds as equity-oriented funds and requires them to maintain at least 65% gross exposure to equities or equity-related securities. The unutilised portions of the portfolio are often invested in short-term debt or money-market instruments to manage liquidity and optimise overall returns.

Instead of attempting to predict the future direction of the market, whether bullish or bearish, arbitrage fund managers try to take advantage of the temporary price spreads in the same asset across markets or across instruments.

Arbitrage fund managers systematically buy a stock in the cash (spot) market at a lower price and sell its corresponding Futures contract in the derivatives market at a higher price. Alternatively, they may exploit small price differences across exchanges by buying a stock on the NSE and selling the same stock on the BSE, or vice versa. By executing numerous such trades, they try to generate relatively steady returns.