Arbitrage is an often-used term in share markets. The arbitrager is an important intermediary that helps in price discovery mechanism in all markets be it equity, money forex or derivatives. There are three important participants that are important in a cash market, the speculator, arbitrager and an investor. In futures market the investor is replaced by a hedger. Arbitrager and
Speculators are often confused and both are termed as Speculators. In this article I wish to explain the difference between the two and show how arbitrage works in the market and its influence on market volatility.
Arbitraging in India has been going on for several years. Initially arbitrage activity was between Stock Exchange Mumbai and all other regional exchanges. Mr. Babulal Bagri the founder of BLB Securities and Mr. Manubhai Maneklal were legendary arbitragers of that era. They traded between Mumbai, Delhi and Kolkatta markets. Arbitraging in those days was done manually and not on any online system. The way the fingers of these brokers flew on telex machines giving trade instructions was an experience by itself. Then it shifted to cashing on price difference between NSE and BSE limited. Today large amount of arbitrage happens between cash and derivative markets. Arbitrage is also possible between the current month and near or far month contracts. In case of Commodity exchanges also there is an arbitrage opportunity between the local cash markets or mandis and the future markets which are popularly known as National Commodity Exchanges.
To give example of an arbitrage transaction, assume that the arbitrager has Rs.10 lacs available for doing arbitrage activity. His targeted return is say 18% p.a. which works to about 1.5% p.m. We will take a simplistic transaction where he does just one trade to earn the return. If some share is quoting at Rs.1000 in one cash market he will look for opportunity to buy at Rs.1000/- and sell at Rs.1015/- or more in another cash market simultaneously. These markets must have different settlement dates otherwise in current rolling settlement scenario it is not possible to give and receive delivery since both happen on the same day.
Now the same example can be extended to cash and derivative segment. Shares are purchased in cash market; and sold in futures market. Delivery of the shares is received in the rolling settlement. Since deliveries are not permitted in futures market a reversal opportunity is looked for before the expiry of contract, otherwise the arbitrager will be left with the delivery of shares. Hence if he gained say Rs.25 per share on the first leg he will reverse the trade upto a loss of Rs.10 in order to achieve his benchmark return of Rs.15.
|Cash Market||Futures Market||Profit / (loss)||Remarks|
|Quantity||+1000||-1000||Transaction done on 1st day
of the month
|Price||1000||1025||Profit Rs.25 per share|
|Quantity||-1000||+1000||Transaction expiry say on 15th
of the month
|Price||1015||1020||Loss Rs.5 per share|
|Investment||-1015000||Sale proceeds received|
|Return on 15 day
|Rs.15000 on cash segment and Rs.5000 on derivatives segment.|
The returns are not often as fantastic but opportunities are many. We also have to deduct from this the cost of brokerage, Securities transaction tax, stock exchange charges and stamp duty. Hence it becomes unviable for an investor unless the transaction costs are very low. The price difference is only for a few minutes or seconds hence it must be captured instantly through a speedy trading system. It should not so happen that one transaction is done and the other one does not go through i.e. if the arbitrager buys and is unable to sell and the market falls then instead of making a profit he will end up with a loss. Automated trading programs are used in order to release both orders so that both the prices are captured simultaneously.
Arbitrage activity thus adds to liquidity in the markets and also helps in balancing the prices of same shares across various markets. Prices continuously balance out once the differences are cash upon. Arbitrage Helps in reducing volatility in markets since continuous flow of orders reduces impact cost and more depth means less volatility.