Arbitrage is the practice of taking advantage of a price difference between two or more markets and considered as an opportunity to buy an asset at a low price then immediately selling it on a different market for a higher price which helps an investor to have a risk free profit at zero cost. Investors in arbitrage usually trade in a very high volume and with fewer margins.
“The basic principle of an arbitrage is sell in overprice market and buy in underpriced market”.
Assume that SBI bank share is trading at Rs 1800/- at cash market and its future contract which will expire in month time, is trading at Rs 1820/-.Since these two values have to converge on the settlement date, it generates the good arbitrage opportunity for the investor. The Investor can pocket the price difference between the future price and spot price for holding a period of one month by buying the SBI bank stock in the cash market and selling the identical quantity in the future market.
As this is a market neutral strategy, the investor won`t be taking any risk whether the price moves up or down during one month holding period. Let’s consider the bullish scenario when both the prices hit Rs 1,900.While the investor will make a gain of Rs 100 in its buy position in the cash market and will report a loss of Rs 80 in its sell position in the future market (Rs 1900-Rs 1820). The net gain will be Rs 20. Now assume a bearish scenario, when both the prices fall to Rs 1,710/-.Though the Investor will make a gain of Rs 110 on its sell position in a future market and it will report a loss of Rs 90 on its buy position in the cash market. Here again the net gain will be restricted to Rs 20.
Arbitrage will only make sense when its profit is more than its cost of acquisition, cost of acquisition is calculated by adding cost of carry with spot price.
Now assumes the Cash Price of Wipro is Rs 1100, Mid Month Future Price is 1000 and cost of carry is Rs 20(10% on 1000 which will be Rs 10 for current (one) month and Rs 20 for mid (second) month.
Arbitrage Profit: Sell @ 1100 – Cost of Acquisition Rs 1020(Spot Price + Cost of carry) = 80.
If the arbitrage profit is coming out to be less than or equal to the cost of acquisition then it is better not to go for an arbitrage opportunity.
Let me explain it further, you have sell it in cash market and bought the same quantity in future market. Now assumes the price moves to 1200, you make a profit of Rs 200 in a future market, loss of Rs 100 in the cash market and their difference would be Rs 100. Now the arbitrage profit would be Rs 80 after deducting the cost of carry from Rs 100.
Now take the bearish scenario when the price goes down to Rs 900, you make a profit of Rs 200 on your sell position in cash market and a loss of Rs 100 in future market. Again the arbitrage profit would be Rs 80 after deducting the cost of carry from the price difference.
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