What is arbitrage?
Arbitrage is a process where the person doing the arbitrage buys and sells the same (or similar) security trading in different markets at different prices. Hence in this process the small price difference between the markets is the profit to the person doing the arbitrage. The risk involved in the process is minimal. (see section on risks).

To illustrate
Say shares of SBI are trading at a price of Rs. 1,000 (on May 1) in the cash segment of NSE and are trading at 1010 in the futures segment (expiry on May 31) after considering transaction costs. In such a situation an arbitrage profit can be made by buying shares of SBI in the cash segment and selling shares of SBI (going short) in the futures segment of SBI.

Since the price in the cash segment and the futures segment will converge on May 31, the person doing the arbitrage gains Rs. 10 on an initial investment of Rs. 1,000 or 1% for a one month investment. The interesting point here is that the profit of Rs. 10 is made whether the stock goes up or down.

For example if the stock goes up to Rs.1,050 on May 31. There will be a profit of Rs. 50 on the investment in SBI and a loss of Rs. 40 on the futures position leaving a net profit of Rs. 10.

Similarly if the stock goes down to Rs. 950 on May 31. There will be a loss of Rs. 50 on the investment in SBI and a profit of Rs. 60 on the futures position leaving a net profit of Rs. 10 again.

Arbitrage aims to produce returns similar to those of fixed income instruments (like bank FDs, bonds or income funds) through the use of equity and equity derivatives.

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 kinds of arbitrage done?
Apart from the cash and futures arbitrage on individual stocks illustrated above, arbitrage may be done in the cash segment between NSE and BSE. Arbitrage can also be done by buying shares of Company A merging with Company B and selling shares of Company B. Another form of arbitrage is buying shares of companies getting de-listed at a price less than the de-listing price. Many similar arbitrage activities can be done. The underlying theme is that a price difference can be leveraged by taking minimal risks.

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. For the purpose of arbitrage activities we charge a minimum brokerage which is designed to cover the regulatory, taxation and exchange costs. Brokerage on arbitrage transactions is not a profit center for us.

What are the fees you will pay?
We charge fees at the rate of 10% of profits plus service tax. Fees are charged on a half yearly basis.

What are the risks?
While arbitrage is a very low risk activity as compared to direct equity investment, there are some risks that you should be aware of. 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. This difference may be favorable or adverse. These differences arise on account of various reasons such as overload on trading systems of the exchange, sudden price volatility, connectivity speed etc. However on an average the execution risk is negligible since the impact over a period of time averages out.

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. However on the next day the investor owns the shares originally purchased and is exposes to an equity risk. He will gain if SBI moves up and lose if SBI moves down.

We have a backup connectivity line to the exchange, UPS systems and a backup site in a nearby building in order to minimise these risks.

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. Please consult your relationship manager with PPFAS about the indicative returns prevailing right now in the markets.

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 realised 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.

What is the minimum sum required?
The minimum amount for arbitrage is Rs. 10,00,000/- (Ten lakhs only).

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