With the likelihood of interest rates moving upwards, arbitrage funds might turn out to

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be a good investment option, investment experts say.

“Any rise in interest rate will increase the spread between the cash and the derivatives market (the cost of carry) and there will more arbitrage opportunities. Overall, arbitrage funds tend to provide almost a risk-free return above the liquid funds,” a senior SBI Mutual Fund executive said, on condition of anonymity.

The cost of carry, which is the differential between cash and future price in percentage terms (on an annualised basis), needs to be higher than the interest rate for an arbitrage opportunity to occur.

Arbitrage funds, which take advantage of price discrepancy between cash and derivatives markets to hedge risk, generate annual returns in the range of 6 per cent to 8 per cent. These funds tend to give returns of 100 to 200 basis points higher than fixed deposit rates.

As per data from Value Research, arbitrage funds like UTI Spread, JP Bank India Alpha and Kotak Equity Arbitrage Fund have clocked returns of 7.68 per cent, 7.72 per cent and 6.83 per cent respectively, over the past one year. At present, fixed deposit rates over a one-year period are at 6.25 per cent for ICICI Bank, 6.25 per cent for Citibank and 6 per cent for State Bank of India to name a few.

“The system-based trading has reduced arbitrage opportunities and lowered spreads. However, as the interest rate has started heading northwards and the equity markets are choppy, there will be increased volatility in the system that can generate better arbitrage opportunities and increase returns,” said Jagannadham Thunuguntla, head equity, SMC Capital.

Since arbitrage funds have a tax advantage over liquid funds, returns from the former have become more attractive for investors. Arbitrage funds are taxed like equity funds at 15 per cent for short-term capital gains. However, 28 per cent is deducted from liquid funds as dividend distribution tax (DDT), which makes returns from these funds go down further.

“While the premium on futures to cash keeps expanding and contracting in a volatile market, the outlook is quite good for these funds in the coming months as markets are expected to remain volatile,” the SBI Mutual Fund executive added.

The arbitrage is sought by taking advantage of the mispricing between the cash and the derivatives market. Now let’s understand how this works.

Suppose the stock price of X is quoting at Rs 100. Let's say the stock is also traded in derivatives segment, where its future price is trading at Rs 110. In such a case, one can make a risk-free profit by selling a futures contract of X at Rs 110 and buy an equivalent number of shares in the equity spot market at Rs 100.

When settlement day arrives, irrespective of whether the stock price has risen or fallen in the interim, one would still make the same amount of money. It is because on the date of expiry (settlement date), the price of the equity shares and their stock futures will tend to coincide.

Now, all one has to do is to reverse the initial transaction, that is buy back the contract in the futures market and sell off the equity. In this manner, the investor earns the spread by taking an arbitrage position.