PROJECT ON ARBITRAGE

DIPTI SHETTY- 42

RIDDHI KHANDARE-19

SUBMITTED TO:- KANTHI MAM.

Introduction:

A central idea in modern finance is the law of one price. This states that
in a competitive market, if two assets are equivalent from the point of
view of risk and return, they should sell at the same price.
If the price of the same asset is different in two markets, there will be
operators who will buy in the market where the asset sells cheap and
sell in the market where it is costly. This activity termed as arbitrage,
involves the simultaneous purchase and sale of the same or essentially
similar security in two different markets for advantageously different
prices.

Theoretical arbitrage requires no capital, entails no risk and appears

to be an easy way of earning profits. However, real–world arbitrage
calls for large outlay of capital, entails some risk and is a lot more
complex than the textbook definition suggests. A major weak link in
India’s financial sector today is inadequate knowledge about arbitrage
Definition:

An arbitrage opportunity is the opportunity to buy an asset at a low price

then immediately selling it on a different market for a higher price.

Meaning:

In economics and finance, arbitrage is the practice of taking advantage

of a price differential between two or more markets: combinations of
matching deals are struck that capitalize upon the imbalance, the profit
being the difference between the market prices. When used by
academics, an arbitrage is a transaction that involves no negative cash
flow at any probabilistic or temporal state and a positive cash flow in at
least one state; in simple terms, a risk-free profit. A person who engages
in arbitrage is called an arbitrageur. The term is mainly applied to trading
in financial instruments.

If the market prices do not allow for profitable arbitrage, the prices are
said to constitute an arbitrage equilibrium or arbitrage-free market
Conditions for arbitrage:

Arbitrage is possible when one of three conditions is met:

•The same asset does not trade at the same price on all markets ("the law
of one price").
•Two assets with identical cash flows do not trade at the same price.
•An asset with a known price in the future does not today trade at its future
price discounted at the risk-free interest rate (or, the asset does not have
negligible costs of storage; as such, for example, this condition holds for
grain but not for securities).

Arbitrage is not simply the act of buying a product in one market and
selling it in another for a higher price at some later time. The transactions
must occur simultaneously to avoid exposure to market risk, or the risk that
prices may change on one market before both transactions are complete.
In practical terms, this is generally only possible with securities and
financial products which can be traded electronically.
Requirements:

True arbitrage requires that the financial instrument is trading at two

different prices, and that the buying and selling trades can be
completed at the same time. The simultaneous trade requirement is
designed to eliminate any risks associated with holding a trade.
Trades based upon the same principles as arbitrage might be buying a commodity
in one location, transporting the commodity to another region, and selling the
commodity in the new region. This type of trade would not be true arbitrage,
because the buying and selling trades would not have occurred at the same
time.

Examples

Stock and stock futures - Buying a stock and selling a single stock futures
contract.
Stock on different exchanges - Buying a stock on one exchange and selling the
stock on another exchange.
Mergers - Buying the stock of a company being acquired, and selling the stock of
the acquiring company.
Operational issues:

In situations where it is possible to exploit mispricing risklessly by

generating perfectly hedged positions and holding on to them till the
final payoff, the following operational aspects need be noted before
implementing arbitrage strategies:

1. For the arbitrage to be a risk–free process, the arbitrageur

must trade simultaneously in two markets

2. All trading involves transactions costs.

But not all mispricing are profitable arbitrage opportunities

Consider the case of hike in onion prices seen in India a few years ago.
Existing arbitrage opportunities:

The launch of the equity derivative markets in India has given rise to a
whole new world of arbitrage.

How is arbitrage actually done?

On an investment of Rs. 100, typically Rs. 15 (15% of investment

amount) is kept aside to meet margins and interim fund requirement
and Rs. 85 is used to buy shares in the cash segment. Simultaneously
the same shares are sold in the futures segment. A part of the Rs. 15
kept aside and some shares are given to the derivatives clearing
member (IL&FS) as margin for the derivatives trade.

The shares are sold in the cash segment and bought in the futures
segment (to reverse out the original transaction) on or before the
expiry date of the futures contract.
 In case the share price rises before expiry of the contract, some
additional margin (mark to market margin) is given to the derivatives
clearing member from the Rs. 15 kept aside.

What are the transaction costs involved?

The transaction costs involved are brokerage, service tax on brokerage,

Securities Transaction Tax (STT), demat charges, derivatives clearing
charges.
 Risks in arbitrage in India:

The basic principles of an arbitrage strategy are straightforward – if an

asset trades at two different prices across two markets, buy where it
trades cheap and sell where it trades expensive.. In reality, almost all
arbitrage requires capital and carries some risk.

What are the risks?

The first risk is the trade execution risk. While all care is taken while
executing trades, there is a difference in the price at which trades finally
get executed and the price that is targeted at the time of initiation of the
trade. These differences arise on account of various reasons such as
overload on trading systems of the exchange, sudden price volatility,
connectivity speed etc.

Mark to market risk typically arises in rising markets because additional

margin is required to be given to the derivatives clearing member. This
may turn out to be more than the money kept aside. However in such a
situation one can reverse the original position and avoid margin
payment.
Risk on clearing corporation and members is the risk of the
exchange or its clearing corporation defaulting. However this is similar
to the risk of a bank going bankrupt and is mainly theoretical.

Connectivity to the exchange, natural disasters etc. pose a risk

since the trades need to be reversed on or before expiry of the
contract. In case we are unable to reverse the position on or before
expiry of the futures contract on account of loss of connectivity or
natural calamity or fire, the original profit (Rs. 10 in the SBI illustration)
is captured.

What are the tax aspects?

The income from arbitrage activities in view of the frequency of trades

and volumes is treated as business income and taxed at similar rates.
It is not covered under short term capital gains. Please consult your
tax adviser regarding the tax aspects.
What are the returns?

The returns from arbitrage activity vary from month to month. Experience
has shown that these are typically better than those being offered by
banks on fixed deposits or those on fixed income mutual funds.

How liquid is my investment in the Arbitrage Scheme?

Investments in arbitrage are very liquid and liquidity is similar to that of

equities. Hence money can be realized in two to three days. However it
is always beneficial to indicate the time horizon for the arbitrage
investment at the time of investing and give a longer withdrawal notice. A
withdrawal notice of 15-20 days is advisable to enable reversal of
transactions at favorable prices
Lack of knowledge:

Arbitrage requires an understanding of the price mechanisms across

markets. Most market players in India are not yet comfortable with
trading on the derivatives market. Even those acquainted with
derivatives market do not understand the intricacies of arbitrage. This
lack of knowledge results in sustained mispricings on the market.
Conclusion:

Arbitrage is a fascinating process.

Besides an understanding of the markets, the processes and the risks
involved, exploiting arbitrage also requires capital and infrastructure. In
some markets, it is possible to detect and capture arbitrage profits
manually.
The execution of an arbitrage trade today is fairly simple. However,
as derivatives get more complicated, the procedures employed for doing
arbitrage will steadily get more complex. This will require new skills to be
Developed and new processes to be formulated.
With the introduction of multiple new products, faster trading mechanisms
and more efficient markets, it may prove to be impossible for the
Human eye to detect or act upon arbitrage. We would then have to rely
on Computers. As computers get into the game, arbitrage opportunities
would be quickly wiped out. There would however always be smart
operators