Most people choose to invest in mutual funds. They provide access to a diversified portfolio of assets by purchasing stocks, bonds, and other securities using funds from numerous investors. Those that manage investors’ portfolios do so with the goal of increasing their capital. A fund’s portfolio is constructed in accordance with its stated objectives. Let us look at what is arbitrage funds with examples in this topic
In order to maximise profits, an arbitrage fund (a form of mutual fund) will frequently buy and sell securities in several markets. Consequently, shoppers are able to take advantage of even tiny price discrepancies in these venues. You have to admit, it’s enticing. Before deciding to invest in an arbitrage fund, you need gain an understanding of how they operate and whether or not they make sense for your portfolio.
What is Arbitrage Fund?
The profitability of arbitrage funds is contingent on the existence of pricing discrepancies between markets. They may invest in stocks on the cash market and then sell those stocks on the futures market. This is due to the fact that the most consequential forms of arbitrage, however little in size, occur between these two marketplaces. To compensate, arbitrage funds must execute several deals annually.
One sort of mutual fund, known as a “arbitrage fund,” invests in both stocks and bonds in order to profit on arbitrage possibilities. Occasionally, the spot market and the futures market will have different asking prices. An arbitrage fund’s manager makes simultaneous purchases and sales of stock. The profit is the difference between the share’s selling price and its acquisition cost.
The primary goal of most mutual funds is to generate capital appreciation by investing in equities and then selling them at a profit. Despite being a subset of mutual funds, arbitrage funds now function in this manner. Investors who wish to profit from unpredictable markets without taking on excessive risk find them appealing.
There are some key distinctions between the traditional market and the futures market. As a market for derivatives, obviously. The value of a futures contract does not reflect the current market value of the underlying stock. Instead, they reflect the average investor’s anticipation of the stock’s future value. It takes time for a share to change hands on the futures market. When a futures contract expires, the negotiated purchase price is applied to the sale of the underlying stock.
Example of Arbitrage Funds
Keep in mind that the money made by arbitrage funds is based on the difference in prices. Stocks are bought on the cash market and futures contracts are sold if investors are anticipating a price increase. In a bearish market, arbitrage funds will purchase futures contracts at lower prices in order to profit on the difference between the futures and cash markets.
Let’s revisit our earlier discussion of the PQR Company. Perhaps the company’s stock is selling for $20 per share today, but most investors anticipate a price increase in the coming month. A futures contract with a one-month maturity date may be more valuable under those circumstances. The arbitrage profit is the difference between the current price of PQR stock and its futures price.
Buying and selling shares of stock on various exchanges is another way that arbitrage funds might generate profits. For instance, they may purchase a share of stock on the NYSE for $57 and immediately sell it on the London Stock Exchange for $57.15. (LSE). Some investors may find the ups and downs of arbitrage funds more unsettling than those of bond, money market, or long-term stock funds, depending on their investing aims and tolerance for risk.
How Does Arbitrage Mutual Funds Function?
Let’s examine the two potential contexts for arbitrage. First, we’ll examine price arbitrage, which occurs when two markets have differing pricing. Suppose a share of XYZ Limited’s stock sells for Rs. 2000 on the Bangalore Stock Exchange (BgSE) and Rs. 2020 on the Ahmedabad Stock Exchange (ASE). If an arbitrage fund’s manager is aware of this, he will simultaneously acquire shares on the BgSE and sell them on the ASE. In this way, he can earn Rs. 20 per share (after deducting the transaction charges) with no downside.
The second kind of arbitrage occurs when there is a price gap between the cash market and the futures market. To illustrate, suppose that a share of XYZ Limited sells for Rs. 2000 in the cash market but Rs. 2015 in the futures market. The arbitrage fund’s manager will acquire shares in the cash market and then enter into a futures contract to sell the shares at Rs. 2015. He sells the shares on the futures market at the end of the month and makes Rs. 15 per share (minus transaction expenses) with no downside.
Conclusion
If you haven’t heard of arbitrage funds, you’re not alone. They stand out from standard mutual funds in this respect. A key distinction between arbitrage funds and other types of funds is that the former place big orders in the hope of profiting from price discrepancies between markets for the same security. Therefore, investors can benefit from market volatility without taking on undue risk. While arbitrage funds may seem appealing at first glance, it is important to discuss their potential role in your investment portfolio with a seasoned financial professional. Also learn about bond market to grab tight hold on the topic.