Arbitraging cash and futures

INVESTING

Arbitrageurs are back in the limelight because of opportunities available in some blue chip shares where traded volumes are good. Investors can make a lot of money if they are smart, especially at the time of expiry of derivatives contracts.

Marketmen said the rate differential on the two exchanges usually surfaces on the last day of the derivatives settlement when investors try to square off their positions.

Investors having cash as well as physical shares take the opportunity in the price differential by selling shares on one exchange at higher levels and buying the same from another exchange at a lower price.

Traditionally, arbitrage was done between the cash segments of the Bombay Stock Exchange (BSE) and National Stock Exchange (NSE).

Investors will have noted the difference in the trading price of a stock on the BSE and the NSE.

If there is a reasonable difference in prices, the arbitrageur will buy on one exchange where the price is low and sell it on the other where it is higher. The prices are watched closely and if the difference between NSE and BSE prices shrinks or is on a par, the transactions are squared off within the trading day.

If the differential exists for the whole day, the arbitrageur will deliver the stock that he has sold at a higher price, and take delivery of the same share from the exchange where the price was lower.

A Mumbai broker, who is also an active arbitrageur, said, "Arbitrage between cash and derivatives (futures) is more prevalent now. There are two types of arbitrage "" cash (done when futures are in contango) and share (done when futures are in backwardation). There are also two types of arbitrageurs. One set is more like day traders or jobbers, playing on spreads between cash and futures and capturing jobbing differences wherever possible. The other set is more like medium-term investors, who are interested in a fixed income stream for a medium term without taking any credit risk or underlying view."

The first set of arbitrageurs buy cash and sell futures whenever there is a contango and the yields are attractive.

They tend to square up on the same day when the difference shrinks. For example, say the Tata Motors share cash price is Rs 480 and the futures price is Rs 485.50.

Since the markets have been choppy, the cost of carry between the futures and spot varies. Supposing one initiates a trade at a cost of carry of Rs 5.50. Whenever the difference shrinks to Rs 2.50-Rs 3 in the same day, the person reverses the position.

He keeps doing this in reasonable quantities throughout the day.

Typically, he also tends to do jobbing, when initiating the position and takes an underlying view of the counter at that specific time.

If his view is that the Tata Motors may going up, he buys and waits for a small period of time before selling the futures. If the counter has momentum and the stock goes up "" for example, becomes Rs 481.20 "" he could look at selling the stock immediately in the cash market, capturing the difference. This set of trader/arbitrageur is more vibrant, taking calculated risks at jobbing, trading and arbitrage.

Investors who would want to beat the risk-free rate of return or the liquid fund yield are the other type of arbitrageurs. They are interested in making a fixed rate of annualised return without taking any view on the underlying, or zero credit risk.

For example, say the Tata Steel spot price is Rs 450 and futures is at Rs 458, with 28 days to expiry of the futures contract. Funds will be deployed for 30 days (Considering T+2 settlement of cash market and T+1 for derivatives).

If, for this period and net of transaction cost, one takes a pre-tax annualised yield of 12 per cent, then this set of arbitrageurs shall come in with funds. They will keep this arbitrage position open till they find spot and futures trading at parity.

In any case, on the expiry day, the futures shall converge with spot. Hence, they shall try locking in a sizeable amount of funds when the yields are present. This is the "net debit" strategy of arbitrage since one shall have to pay for the stock as well as margin for a futures position.

However, the annualised yield also have to be considered on the total investment outlay.

Investors can also at look at taking up share arbitrage. For instance, a portfolio investor has the Punjab National Bank share in his portfolio. He finds that the PNB futures price is at Rs 370, whereas spot is at Rs 377.

In such cases, the investor shall sell his PNB in the spot market and buy futures. This is the "net credit" strategy since he shall receive funds from the exchange.

From the money that he receives, he would pay the margin of futures and put the remaining in a liquid fund for a brief while. This can actually lift the locked-in yield even further.