Arbitrage - Encashing the Difference

Posted in Finance Articles, Total Reads: 3222 , Published on 27 March 2011
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In finance, we many times come across terms like arbitrage, arbitrage trading, arbitrage mutual funds etc.  What is arbitrage? Arbitrage is a practice to capture the price differential between two or more markets to earn a risk-free profit. Trick is to simultaneously enter into deals in two markets where the price differential exists.

 

 

Arbitrage

For example, one can buy shares of Company ABC in cash market at Rs 100 a piece and at the same time sell a future contract of an equal number of shares at Rs 105. There is a price differential of Rs 5 per share. By the end of the expiry of the contract, prices in cash and futures market converge, offering a risk-free profit.

True believers of efficient market hypothesis will insist that arbitrage opportunities do not exist. But due to inefficiencies in the market there exist arbitrage opportunities. The arbitrage spread limits the rate of return. Narrow the spread lesser is the return. In the efficient markets, this spread tend sto be very narrow.

There are many who identify arbitrage opportunities across asset classes and markets. These are called arbitrageurs. Continuous tracking of markets and availability of good amount of cash are must to carry out the role of an arbitrageur to make a decent size of money. With efficient markets resulting into narrow spreads, it makes life difficult for an individual with limited resources. Arbitrage Mutual fund come to the rescue of those who want to take advantage of the arbitrage opportunities existing in the market but lack the expertise and resources.  The schemes here aim to make risk-free profits, by capturing the price differentials across markets arising out of the inefficiencies of the markets. The expected rate of return can be slightly above that of one offered by bank fixed deposits of a similar tenure.

One of the arbitrage strategy used by many arbitrageurs is dividend arbitrage. Dividend arbitrage is an options trading strategy that involves purchasing put op¬tions and an equivalent amount of underlying stock before the ex-dividend date and then exercising the put after collecting the dividend. Hence, it gives an opportunity to earn a small amount of gain in small period of time.

Put option is basically a contract giving the owner the right, but not the obligation, to sell a specified amount of an underlying security at a specified price within a specified time. For example you buy March 20 ITC 10 Put, you have right to sell 100 shares of ITC at Rs 10 until march 20. If share of ITC fall to Rs 6 then you can purchase 100 shares at Rs 6 from the market and exercise your put option to sell these shares at Rs 10 making a profit of (10-6)*100=400. This is maximum profit which can be made ignoring the premium.

Let’s understand dividend arbitrage with the help of an example.  Suppose that stock ABC is trading at Rs200 and is paying a Rs4 dividend in one week’s time. A put option with expiry three weeks from now and a strike price of Rs220 is selling for Rs22. A trader wishing to structure a dividend arbitrage can purchase one contract for Rs2,200 and 200 shares for Rs20,000, for a total cost of Rs22,200. In one week’s time, the trader will collect the Rs400 in dividends and the put option to sell the stock for Rs22,000. The total earned from the dividend and stock sale is Rs22,400, for a profit of Rs200.

Generally, this strategy is best when used on a security with low volatility (causing lower options premiums) and a high dividend. Hence, it creates an opportunity to create profits while as¬suming very low to no risk. Most of the FMCG companies like HUL, ITC and PSU companies like ONGC, NTPC fall under this category.

 


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