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VIVEK COLLEGE OF COMMERCE

1ROLE OF HEDGERS, SPECULATORS & ARBITRAGEURS IN EQUITY MARKET

EXECUTIVE SUMMARY


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INDEX

Sr.No. TOPIC Pg.No.


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INTRODUCTION

A stock market or equity market is a public market (a loose network of economictransactions, not a physical facility or discrete entity) for the trading of company

stock (shares) and derivatives at an agreed price; these are securities listed on astock exchange as well as those only traded privately. A stock exchange has beendefined by the Securities Contract (Regulation) Act, 1956 as an organization,association or body of individuals established for regulating, and controlling ofsecurities.

The Indian equity market depends on three factors

Funding into equity from all over the world Corporate houses performance Monsoons

The stock market in India does business with two types of fund namely privateequity fund and venture capital fund. It also deals in transactions which are basedon the two major indices - Bombay Stock Exchange (BSE) and National StockExchange of India Ltd. (NSE).

The market also includes the debt market which is controlled by wholesale dealers,primary dealers and banks. The equity indexes are allied to countries beyond the

border as common calamities affect markets. E.g. Indian and Bangladesh stockmarkets are affected by monsoons.

The equity market is also affected through trade integration policy. The countryhas advanced both in foreign institutional investment (FII) and trade integrationsince 1995. This is a very attractive field for making profit for medium and longterm investors, short-term swing and position traders and very intraday traders.

The Indian market has 22 stock exchanges. The larger companies are enlisted withBSE and NSE. The smaller and medium companies are listed with OTCEI (OverThe counter Exchange of India). The functions of the Equity Market in India aresupervised by SEBI (Securities Exchange Board of India).

History of Indian Equity Market The history of the Indian equity market goes backto the 18th century when securities of the East India Company were traded. Till theend of the 19th century, the trading of securities was unorganized and the main


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trading centers were Calcutta (now Kolkata) and Bombay (now Mumbai).

Trade activities prospered with an increase in share price in India with Bombaybecoming the main source of cotton supply during the American Civil War (1860-61). In 1865, there was drop in share prices. The stockbroker associationestablished the Native Shares and Stock Brokers Association in 1875 to organizetheir activities. In 1927, the BSE recognized this association, under the BombaySecurities Contracts Control Act, 1925.

The Indian Equity Market was not well organized or developed beforeindependence. After independence, new issues were supervised. The timing,floatation costs, pricing, interest rates were strictly controlled by the Controller ofCapital Issue (CII). For four and half decades, companies were demoralized andnot motivated from going public due to the rigid rules of the Government.

In the 1950s, there was uncontrollable speculation and the market was known as'Satta Bazaar'. Speculators aimed at companies like Tata Steel, Kohinoor Mills,Century Textiles, Bombay Dyeing and National Rayon. The Securities Contracts(Regulation) Act, 1956 was enacted by the Government of India. Financialinstitutions and state financial corporation were developed through an establishednetwork.

In the 60s, the market was bearish due to massive wars and drought. Forwardtrading transactions and 'Contracts for Clearing' or 'badla' were banned by theGovernment. With financial institutions such as LIC, GIC, some revival in themarkets could be seen. Then in 1964, UTI, the first mutual fund of India wasformed.

In the 70's, the trading of 'badla' resumed in a different form of 'hand deliverycontract'. But the Government of India passed the Dividend Restriction Ordinanceon 6th July, 1974. According to the ordinance, the dividend was fixed to 12% ofFace Value or 1/3 rd of the profit under Section 369 of The Companies Act, 1956whichever is lower.

This resulted in a drop by 20% in market capitalization at BSE (Bombay StockExchange) overnight. The stock market was closed for nearly a fortnight.Numerous multinational companies were pulled out of India as they had todissolve their majority stocks in India ventures for the Indian public under FERA,1973.


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The 80's saw a growth in the Indian Equity Market. With liberalized policies of thegovernment, it became lucrative for investors. The market saw an increase of stockexchanges, there was a surge in market capitalization rate and the paid up capital ofthe listed companies.

The 90s was the most crucial in the stock market's history. Indians became awareof 'liberalization' and 'globalization'. In May 1992, the Capital Issues (Control) Act,1947 was abolished. SEBI which was the Indian Capital Market's regulator wasgiven the power and overlook new trading policies, entry of private sector mutualfunds and private sector banks, free prices, new stock exchanges, foreigninstitutional investors, and market boom and bust.

In 1990, there was a major capital market scam where bankers and brokers wereinvolved. With this, many investors left the market. Later there was a securities

scam in 1991-92 which revealed the inefficiencies and inadequacies of the Indianfinancial system and called for reforms in the Indian Equity Market.

Two new stock exchanges, NSE (National Stock Exchange of India) established in1994 and OTCEI (Over the Counter Exchange of India) established in 1992 gaveBSE a nationwide competition. In 1995-96, an amendment was made to theSecurities Contracts (Regulation) Act, 1956 for introducing options trading. InApril 1995, the National Securities Clearing Corporation (NSCC) and inNovember 1996, the National Securities Depository Limited (NSDL) were set upfor demutualised trading, clearing and settlement. Information Technology scripswere the major players in the late 90s with companies like Wipro, Satyam, andInfosys.

In the 21st century, there was the Ketan Parekh Scam. From 1st July 2001, 'Badla'was discontinued and there was introduction of rolling settlement in all scrips. InFebruary 2000, permission was given for internet trading and from June, 2000,futures trading started.


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PARTICIPANT OF EQUITY MARKET

Participantsof EquityMarket

Investor

StockBroker

StockExchange

Depositories

SpeculatorSEBI

Hedger Arbitrageurs

BanksFII


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HEDGERS IN EQUITY MARKETS

In finance, a hedge is a position established in one market in an attempt to offset

exposure to price changes or fluctuations in some opposite position with the goalof minimizing one's exposure to unwanted risk. There are many specific financialvehicles to accomplish this including policies, forward, swaps, options, many typesof over-the-counter and derivative products, and perhaps most popularly, futurescontracts. Public futures markets were established in the 19th century to allowtransparent, standardized, and efficient hedging of agricultural commodity prices;they have since expanded to include futures contracts for hedging the valuesof energy, precious metals, foreign currency, and interest rate fluctuations.

These investors have a position (i.e., have bought stocks) in the underlying market

but are worried about a potential loss arising out of a change in the asset price inthe future. Hedgers participate in the derivatives market to lock the prices at whichthey will be able to transact in the future. Thus, they try to avoid price risk throughholding a position in the derivatives market. Different hedgers take differentpositions in the derivatives market based on their exposure in the underlyingmarket. A hedger normally takes an opposite position in the derivatives market towhat he has in the underlying market.Hedging in futures market can be done through two positions, viz. short hedge andlong hedge.

Short Hedge

A short hedge involves taking a short position in the futures market. Short hedgeposition is taken by someone who already owns the underlying asset or isexpecting a future receipt of the underlying asset.For example, an investor holding Reliance shares may be worried about adversefuture price movements and may want to hedge the price risk. He can do so by

holding a short position in the derivatives market. The investor can go short inReliance futures at the NSE. This protects him from price movements in Reliancestock. In case the price of Reliance shares falls, the investor will lose money in theshares but will make up for this loss by the gain made in Reliance Futures. Notethat a short position holder in a futures contract makes a profit if the price of theunderlying asset falls in the future. In this way, futures contract allows an investorto manage his price risk.


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Similarly, a sugar manufacturing company could hedge against any probable lossin the future due to a fall in the prices of sugar by holding a short position in thefutures/ forwards market. If the prices of sugar fall, the company may lose on thesugar sale but the loss will be offset by profit made in the futures contract.

Long Hedge

A long hedge involves holding a long position in the futures market. A Longposition holder agrees to buy the underlying asset at the expiry date by paying theagreed futures/ forward price. This strategy is used by those who will need toacquire the underlying asset in the future.

For example, a chocolate manufacturer who needs to acquire sugar in the futurewill be worried about any loss that may arise if the price of sugar increases in thefuture. To hedge against this risk, the chocolate manufacturer can hold a longposition in the sugar futures. If the price of sugar rises, the chocolate manufacturemay have to pay more to acquire sugar in the normal market, but he will becompensated against this loss through a profit that will arise in the futures market.Note that a long position holder in a futures contract makes a profit if the price ofthe underlying asset increases in the future.

Long hedge strategy can also be used by those investors who desire to purchase theunderlying asset at a future date (that is, when he acquires the cash to purchase theasset) but wants to lock the prevailing price in the market. This may be because hethinks that the prevailing price is very low.

For example, suppose the current spot price of Wipro Ltd. is Rs. 250 per stock. Aninvestor is expecting to have Rs. 250 at the end of the month. The investor feelsthat Wipro Ltd. is at a very attractive level and he may miss the opportunity to buythe stock if he waits till the end of the month. In such a case, he can buy Wipro

Ltd. in the futures market. By doing so, he can lock in the price of the stock.Assuming that he buys Wipro Ltd. in the futures market at Rs. 250 (t his becomeshis locked-in price), there can be three probable scenarios:

Scenario I: Price of Wipro Ltd. in the cash market on expiry date is Rs. 300.As futures price is equal to the spot price on the expiry day, the futures price ofWipro would be at Rs. 300 on expiry day. The investor can sell Wipro Ltd in the


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futures market at Rs. 300. By doing this, he has made a profit of 300 250 = Rs.50 in the futures trade. He can now buy Wipro Ltd in the spot market at Rs. 300.Therefore, his total investment cost for buying one share of Wipro Ltd equalsRs.300 (price in spot market) 50 (profit in futures market) = Rs.250. This is theamount of money he was expecting to have at the end of the month. If the investorhad not bought Wipro Ltd futures, he would have had only Rs. 250 and would havebeen unable to buy Wipro Ltd shares in the cash market. The futures contracthelped him to lock in a price for the shares at Rs. 250.

Scenario II: Price of Wipro Ltd in the cash market on expiry day is Rs. 250.As futures price tracks spot price, futures price would also be at Rs. 250 on expiryday. The investor will sell Wipro Ltd in the futures market at Rs. 250. By doingthis, he has made Rs. 0 in the futures trade. He can buy Wipro Ltd in the spotmarket at Rs. 250. His total investment cost for buying one share of Wipro will be= Rs. 250 (price in spot market) + 0 (loss in futures market) = Rs. 250.

Scenario III: Price of Wipro Ltd in the cash market on expiry day is Rs. 200.As futures price tracks spot price, futures price would also be at Rs. 200 on expiryday. The investor will sell Wipro Ltd in the futures market at Rs. 200. By doingthis, he has made a loss of 200 250 = Rs. 50 in the futures trade. He can buyWipro in the spot market at Rs. 200.Therefore, his total investment cost for buying one share of Wipro Ltd will be =200 (price in spot market) + 50 (loss in futures market) = Rs. 250.

Thus, in all the three scenarios, he has to pay only Rs. 250. This is an example of aLong Hedge.


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PROCESS OF HEDGING

STEP 1: IDENTIFY THE RISKS

Before management can begin to make any decisions about hedging, it must firstidentify all of the risks to which the corporation is exposed. These risks willgenerally fall into two categories: operating risk and financial risk. For most non-financial organizations, operating risk is the risk associated with manufacturingand marketing activities. A computer manufacturer, for example, is exposed to theoperating risk that a competitor will introduce a technologically superior productwhich takes market share away from its leading model. In general, operating riskscannot be hedged because they are not traded.

The second type of risk, financial risk, is the risk a corporation faces due to itsexposure to market factors such as interest rates, foreign exchange rates andcommodity and stock prices. Financial risks, for the most part, can be hedged dueto the existence of large, efficient markets through which these risks can betransferred.

In determining which risks to hedge, the risk manager needs to distinguish betweenthe risks the company is paid to take and the ones it is not. Most companies willfind they are rewarded for taking risks associated with their primary businessactivities such as product development, manufacturing and marketing. Forexample, a computer manufacturer will be rewarded (i.e., its stock price willappreciate) if it develops a technologically superior product or for implementing asuccessful marketing strategy.

Most corporations, however, will find they are not rewarded for taking risks whichare not central to their basic business (i.e., interest rate, exchange rate, andcommodity price risk). The computer manufacturer in the previous example isunlikely to see its stock price appreciate just because it made a successful bet onthe dollar/yen exchange rate.

Another critical factor to consider when determining which risks to hedge is themateriality of the potential loss that might occur if the exposure is not hedged. Asnoted previously, a corporation's optimal risk profile balances the benefits ofprotection against the costs of hedging. Unless the potential loss is material (i.e.,large enough to severely impact the corporation's earnings) the benefits of hedgingmay not outweigh the costs, and the corporation may be better off not hedging.


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STEP 2: DISTINGUISH BETWEEN HEDGING AND SPECULATING

One reason corporate risk managers are sometimes reluctant to hedge is becausethey associate the use of hedging tools with speculation. They believe hedging withderivatives introduces additional risk. In reality, the opposite is true. A properlyconstructed hedge always lowers risk. It is by choosing not to hedge that managersregularly expose their companies to additional risks.

Financial risks - regardless of whether or not they are managed - exist in everybusiness. The manager who opts not to hedge is betting that the markets will eitherremain static or move in his favor. For example, a U.S. computer manufacturerwith French franc receivables that decides to not hedge its exposure to the Frenchfranc is speculating that the value of the French franc relative to the U.S. dollar

will either remain stable or appreciate. In the process, the manufacturer is leavingitself exposed to the risk that the French franc will depreciate relative to the U.S.dollar and hurt the company's revenues.

A reason some managers choose not to hedge, thereby exposing their companies toadditional risk, is that not hedging often goes unnoticed by the company's board ofdirectors. Conversely, hedging strategies designed to reduce risk often receive agreat deal of scrutiny. Corporate risk managers who wish to use hedgingtechniques to improve their company's risk profile must educate their board ofdirectors about the risks the company is naturally exposed to when it does nothedge.

STEP 3: EVALUATE THE COSTS OF HEDGING IN LIGHT OF THE

COSTS OF NOT HEDGING

The cost of hedging can sometimes make risk managers reluctant to hedge.Admittedly, some hedging strategies do cost money. But consider the alternative.To accurately evaluate the cost of hedging, the risk manager must consider it inlight of the implicit cost of not hedging. In most cases, this implicit cost is the

potential loss the company stands to suffer if market factors, such as interest ratesor exchange rates, move in an adverse direction. In such cases the cost of hedgingmust be evaluated in the same manner as the cost of an insurance policy, that is,relative to the potential loss.

In other cases, derivative transactions are substitutes for implementing a financingstrategy using a traditional method. For example, a corporation may combine a


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floating-rate bank borrowing with a floating-to-fixed-rate swap as an alternative toissuing fixed-rate debt. Similarly, a manufacturer may combine the spot purchaseof a commodity with a floating-to-fixed swap instead of buying the commodity andstoring it. In most cases where derivative strategies are used as substitutes fortraditional transactions, it is because they are cheaper. Derivatives tend to becheaper because of the lower transaction costs that exist in highly liquid forwardand options markets.

STEP 4: USE THE RIGHT MEASURING STICK TO EVALUATE HEDGE

PERFORMANCE

Another reason for not hedging often cited by corporate risk managers is the fear

of reporting a loss on a derivative transaction. This fear reflects widespreadconfusion over the proper benchmark to use in evaluating the performance of ahedge. The key to properly evaluating the performance of all derivativetransactions, including hedges, lies in establishing appropriate goals at the onset.

As noted previously, many derivative transactions are substitutes for traditionaltransactions. A fixed-rate swap, for example, is a substitute for the issuance of afixed-rate bond. Regardless of market conditions, the swap's cash flows will mirrorthe bonds. Thus, any money lost on the swap would have been lost if thecorporation had issued a bond instead. Only if the swap's performance is evaluatedin light of management's original objective (i.e., to duplicate the cash flows of thebond) will it become clear whether or not the swap was successful.

STEP 5: DON'T BASE YOUR HEDGE PROGRAM ON YOUR MARKET

VIEW

Many corporate risk managers attempt to construct hedges on the basis of theiroutlook for interest rates, exchange rates or some other market factor. However,

the best hedging decisions are made when risk managers acknowledge that marketmovements are unpredictable. A hedge should always seek to minimize risk. Itshould not represent a gamble on the direction of market prices.


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STEP 6: UNDERSTAND YOUR HEDGING TOOLS

A final factor that deters many corporate risk managers from hedging is a lack offamiliarity with derivative products. Some managers view derivatives asinstruments that are too complex to understand. The fact is that most derivativesolutions are constructed from two basic instruments: forwards and options, whichcomprise the following basic building blocks:

FORWARDS OPTIONS

SWAPS CAPS

FUTURES FLOORS

FRAs PUTS

LOCKS CALLS

SWAPTIONS

The manager who understands these will be able to understand more complexstructures which are simply combinations of the two basic instruments.

STEP 7: ESTABLISH A SYSTEM OF CONTROLS

As is true of all other financial activities, a hedging program requires a system ofinternal policies, procedures and controls to ensure that it is used properly. Thesystem, often documented in a hedging policy, establishes, among other things, thenames of the managers who are authorized to enter into hedges; the managers whomust approve trades; and the managers who must receive trade confirmations. Thehedging policy may also define the purposes for which hedges can and cannot be

used. For example, it might state that the corporation uses hedges to reduce risk,but it does not enter into hedges for trading purposes. It may also set limits on thenotional value of hedges that may be outstanding at any one time. A clearlydefined hedging policy helps to ensure that top management and the company'sboards of directors are aware of the hedging activities used by the corporation'srisk managers and that all risks are properly accounted for and managed.


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ROLE OF SPECULATORS

A Speculator is one who bets on the derivatives market based on his views on thepotential movement of the underlying stock price. Speculators take large,calculated risks as they trade based on anticipated future price movements. Theyhope to make quick, large gains; but may not always be successful. They normallyhave shorter holding time for their positions as compared to hedgers. If the price ofthe underlying moves as per their expectation they can make large profits.However, if the price moves in the opposite direction of their assessment, thelosses can also be enormous.

There are numerous different types of stock market speculators, each with theirown view of how to capitalize off price fluctuations in the stock market. The mostcommon type of speculator is the momentum player, who likes to throw his moneyafter stocks that have already gone up very far. His motto isn't buy low, sell high,but rather, buy high, sell higher. The other principal type of speculator is acontrarian, who is almost the polar opposite of a momentum chaser. He will seekto short-sell stocks he considers overbought and overvalued, while purchasingshares of companies that are down and out of favor.

IllustrationCurrently ICICI Bank Ltd (ICICI) is trading at, say, Rs. 500 in the cash market andalso at Rs. 500 in the futures market (assumed values for the example only). Aspeculator feels that post the RBIs policy announcement, the share price of ICICIwill go up. The speculator can buy the stock in the spot market or in the derivativesmarket. If the derivatives contract size of ICICI is 1000 and if the speculator buysone futures contract of ICICI, he is buying ICICI futures worth Rs 500 X 1000 =Rs. 5,00,000. For this he will have to pay a margin of say 20% of the contractvalue to the exchange. The margin that the speculator needs to pay to the exchangeis 20% of Rs. 5, 00,000 = Rs. 1, 00,000. This Rs. 1, 00,000 is his total investment

for the futures contract.If the speculator would have invested Rs. 1, 00,000 in the spot market, he couldpurchase only 1, 00,000 / 500 = 200 shares. Let us assume that post RBIannouncement price of ICICI share moves to Rs. 520. With one lakh investmenteach in the futures and the cash market, the profits would be: (520 500) * 1,000 = Rs. 20,000 in case of futures market and (520 500) * 200 = Rs. 4000 in the case of cash market.


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It should be noted that the opposite will result in case of adverse movement instock prices, wherein the speculator will be losing more in the futures market thanin the spot market. This is because the speculator can hold a larger position in thefutures market where he has to pay only the margin money.

THE ECONOMIC BENEFITS OF SPECULATION

Market efficiency and liquidityIf a certain marketfor example, pork bellieshad no speculators, then only

producers (hog farmers) and consumers (butchers, etc.) would participate in thatmarket. With fewer players in the market, there would be a larger spread betweenthe current bid and ask price of pork bellies. Any new entrant in the market whowants to either buy or sell pork bellies would be forced to accept an illiquidmarket and market prices that have a large bid-ask spread or might even find itdifficult to find a co-party to buy or sell to. A speculator (e.g., a pork dealer) mayexploit the difference in the spread and, in competition with other speculators,reduce the spread, thus creating a more efficient market.

Bearing risksSpeculators also sometimes perform a very important risk bearing role that isbeneficial to society. For example, a farmer might be considering planting corn onsome unused farmland. Alas, he might not want to do so because he is concernedthat the price might fall too far by harvest time. By selling his crop in advance at a

fixed price to a speculator, the farmer can hedge the price risk and is now willingto plant the corn. Thus, speculators can actually increase production through theirwillingness to take on risk.


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Finding environmental and other risksHedge funds that do fundamental analysis "are far more likely than other investorsto try to identify a firms off-balance-sheet exposures", including "environmentalor social liabilities present in a market or company but not explicitly accounted forin traditional numeric valuation or mainstream investor analysis", and hence makethe prices better reflect the true quality of operation of the firms.

Shorting

Shorting may act as a canary in a coal mine to stop unsustainable practicesearlier and thus reduce damages and forming market bubbles.


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ROLE OF ARBITRAGEURS

In economics and finance, arbitrage is the practice of taking advantage ofa price difference between two or more markets; striking a combination ofmatching deals that capitalize upon the imbalance, the profit being the differencebetween the market prices. When used by academics, an arbitrage is a transactionthat involves no negative cash flow at any probabilistic or temporal state and apositive cash flow in at least one state; in simple terms, it is the possibility of arisk-free profit at zero cost.

In principle and in academic use, an arbitrage is risk-free; in common use, asin statistical arbitrage, it may refer to expectedprofit, though losses may occur, andin practice, there are always risks in arbitrage, some minor (such as fluctuation ofprices decreasing profit margins), some major (such as devaluation of a currency orderivative). In academic use, an arbitrage involves taking advantage of differencesin price of a single asset or identical cash-flows; in common use, it is also used torefer to differences between similarassets (relative value or convergence), asin merger arbitrage.

People who engage in arbitrage are called arbitrageurs such as a bank or

brokerage firm. The term is mainly applied to trading in financial instruments, suchas bonds, stocks, derivatives, commodities and currencies.

Arbitrageurs attempt to profit from pricing inefficiencies in the market by makingsimultaneous trades that offset each other and capture a risk-free profit. Anarbitrageur may also seek to make profit in case there is price discrepancy betweenthe stock price in the cash and the derivatives markets.
http://en.wikipedia.org/wiki/Economicshttp://en.wikipedia.org/wiki/Financehttp://en.wikipedia.org/wiki/Financehttp://en.wikipedia.org/wiki/Economics


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Arbitrage is possible when one of three conditions is met:

The same asset does not trade at the same price on all markets ("the law ofone price").

Two assets with identical cash flows do not trade at the same price. An asset with a known price in the future does not today trade at its future

price discounted at the risk-free interest rate (or, the asset does not havenegligible costs of storage; as such, for example, this condition holds forgrain but not for securities).

For example, if on 1st August, 2009 the SBI share is trading at Rs. 1780 in the cash

market and the futures contract of SBI is trading at Rs. 1790, the arbitrageur wouldbuy the SBI shares (i.e. make an investment of Rs. 1780) in the spot market andsell the same number of SBI futures contracts. On expiry day (say 24 August,2009), the price of SBI futures contracts will close at the price at which SBI closesin the spot market. In other words, the settlement of the futures contract willhappen at the closing price of the SBI shares and that is why the futures and spotprices are said to converge on the expiry day. On expiry day, the arbitrageur willsell the SBI stock in the spot market and buy the futures contract, both of whichwill happen at the closing price of SBI in the spot market. Since the arbitrageur has

entered into off-setting positions, he will be able to earn Rs. 10 irrespective of theprevailing market price on the expiry date. There are three possible price scenariosat which SBI can close on expiry day. Let us calculate the profit/ loss of thearbitrageur in each of the scenarios where he had initially (1 August) purchasedSBI shares in the spot market at Rs 1780 and sold the futures contract of SBI at Rs.1790:Scenario I: SBI shares closes at a price greater than 1780 (say Rs. 2000) in thespot market on expiry day (24 August 2009) SBI futures will close at the sameprice as SBI i n spot market on the expiry day i.e., SBI futures will also close at Rs.2000. The arbitrageur reverses his previous transaction entered into on 1 August

2009.

Profit/ Loss () in spot market = 20001780 = Rs. 220

Profit/ Loss () in futures market = 1 7902000 = Rs. () 2 1 0

Net profit/ Loss () on both transactions combined = 220210 = Rs. 10 profit.


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Scenario II: SBI shares close at Rs 1780 in the spot market on expiry day (24August 2009)SBI futures will close at the same price as SBI in spot market on expiry day i.e.,SBI futures will also close at Rs 1780. The arbitrageur reverses his previoustransaction entered into on 1 August 2009.

Profit/ Loss () in spot market = 17801 7 8 0 = Rs. 0

Profit/ Loss () in futures market = 17901780 = Rs. 1 0

Net profit/ Loss () on both transactions combined = 0 + 10 = Rs. 10 profit.

Scenario III: SBI shares close at Rs. 1500 in the spot market on expiry day (24

August 2009)Here also, SBI futures will close at Rs. 1500. The arbitrageur reverses his previoustransaction entered into on 1 August 2009.

Profit/ Loss () in spot market = 15001780 = Rs. () 2 8 0

Profit/ Loss () in futures market = 17901500 = Rs. 290

Net profit/ Loss () on both transactions combined = () 280 + 290 = Rs. 10 profit.

Thus, in all three scenarios, the arbitrageur will make a profit of Rs. 10, which wasthe difference between the spot price of SBI and futures price of SBI, when thetransaction was entered into. This is called a risk less profit since once thetransaction is entered into on 1 August, 2009 (due to the price difference betweenspot and futures), the profit is locked. 24Irrespective of where the underlying shareprice closes on the expiry date of the contract, a profit of Rs. 10 is assured. Theinvestment made by the arbitrageur is Rs. 1780 (when he buys SBI in the spotmarket). He makes this investment on 1 August 2009 and gets a return of Rs. 10 onthis investment in 23 days (24 August). This means a return of 0.56% in 23 days. If

we annualize this, it is a return of nearly 9% per annum. One should also note thatthis opportunity to make a risk-less return of 9% per annum will not alwaysremain. The difference between the spot and futures price arose due to someinefficiency (in the market), which was exploited by the arbitrageur by buyingshares in spot and selling futures. As more and more such arbitrage trades takeplace, the difference between spot and futures prices would narrow therebyreducing the attractiveness of further arbitrage.


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PROCESS OF ARBITRAGE

Arbitrage is process of utilizing differences in price in twomarkets to make financial gains. Generally each market has a different demand-supply position and hence price of same product is different in different market.When referred to Indian stock markets, this term generally means taking advantageof price difference between a stock's price in BSE and NSE.

NSE is a much larger stock exchange compared to BSE and hence Demand-supplyratios are slightly different than BSE. Thus there is always some difference of pricebetween a stock's prices on both exchanges. However for most stocks this

difference is very small and no meaningful profit can be made so it is anarbitragers talent to find stocks having a comparatively better difference andexploit it.Apart from this arbitrage is also done between stocks and their ADR (Americandepositary receipts) and GDR (Global Depositary receipts).Many such stocks thatare listed on other exchanges apart from India exhibit such cost differential. Onemore thing giving rise to opportunity is Merger & Acquisitions. Company A isbeing merged with Company B, and this company B will be issuing new shares toCompany A shareholder based on certain swap ratio. Now it might happen that dueto cost differential a profit can be made by selling share A upfront (beforemerging) and buying Share B giving rise to arbitrage opportunity. However inmost cases arbitrage margin is very low and trades of huge amount needs to bedone to make some gain.Hence such activities are limited to large traders and institution. Now many mutualfunds have come up with Arbitrage funds which allow retail investor to take part inarbitrage opportunity.


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THE SCIENCE OF ARBITRAGE

Arbitrage pricing is one of the most important concepts in modern finance. Theorigins of this lie in the efficient market hypothesis. In this section we take a lookat some literature on arbitrage and discuss the theory, operational aspects andimpediments to arbitrage.

Efficient markets hypothesis

Efficient markets hypothesis states that the price of a security must be equal to theexpected present value of the future cash flows on that security. In other words, itstates that the price of a security must be equal to its fundamental value. The twocentral assumptions of the efficient market hypothesis are:

Investors hold rational expectations Arbitrage brings prices towards fundamentals

In an efficient market there are no profitable arbitrage opportunities.By buying underpriced securities and selling overpriced ones, arbitrageurs ensurethat security prices converge to their fundamental values thereby restoring marketefficiency. However, the efficient market hypothesis assumes that arbitrage

strategies are riskless and do not involve capital outlay. Hence professionalarbitrageurs are willing to take unbounded positions in the market. In realityhowever, arbitrage involves risk. An arbitrage strategy is risky even if rationaltraders care only about the final payoff of the arbitrage strategy. In other words, anarbitrage trade is riskless only if a perfect substitute for the mispriced asset exists.Arbitrageurs can rarely fully hedge their arbitrage strategies. Recent literature onthe limits to arbitrage has identified two broad categories of risk:fundamental riskandnoise trader risk.An arbitrage strategy can be risky because the fundamental value of a partiallyhedged portfolio might change over time. Besides, the arbitrageurs model may

often not coincide with the true datagenerating process. Thus, arbitrageurs have tobearfundamental riskeven if they can sustain the arbitrage strategy until the finalpayoff is realized.


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In addition to this, the activity of behavioural noise traders might lead to temporaryprice movements. These price changes temporarily reduce the value of thearbitrage portfolio as prices move even further from fundamental values. Ifarbitrageurs are compelled to liquidate their positions in the intermediate term,then they are forced to take losses when the arbitrage opportunity is greatest. Thisis called the noise trader risk.

Fund managers are afraid that their investors will withdraw their money if theysuffer intermediate shortterm losses even though the arbitrage provides a risklesspositive payoff in the longrun. This paper builds on the insight that distortedprices might become even more distorted in the short run before eventuallyreturning to their normal long run values.

IMPEDIMENTS TO ARBITRAGE

In its purest form, arbitrage requires no capital and is risk free. By simultaneouslyselling and purchasing identical assets at different prices, the arbitrageur captures aprofit with no upfront capital. Unfortunately, pure arbitrage exists only in perfectcapital markets. In the real world, imperfect information and market frictions makearbitrage both capital intensive and risky.They impede arbitrage in two ways:

1. When there is uncertainty over the nature of an apparent mispricing, andadditional learning involves a cost, arbitrageurs may be reluctant to incur thepotentially large fixed costs of entering the business of exploiting the arbitrageopportunity. Uncertainty over the distribution of arbitrage returns, especially overthe mean, will deter arbitrage activity until wouldbe arbitrageurs learn enoughabout the distribution to decide whether the expected payoff from the arbitrage islarge enough to cover the fixed costs of setting up shop. Even with activearbitrageurs, opportunities may persist while the arbitrageurs learn to exploit them.

2. Once the fixed costs of implementing the arbitrage strategy are borne, imperfect

information and market frictions often encourage specialization. Specializationlimits the degree of diversification in the arbitrageurs portfolio and causes him tobear idiosyncratic risks for which he must be rewarded. For instance, if there is apurely random chance that prices will not converge to fundamental value, a highlyspecialized arbitrageur who cannot diversify away this risk will invest less thanone who can. Even if prices eventually converge to fundamental values, the path ofconvergence may be long and bumpy. While waiting for the prices of the


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mispriced securities to converge, they may temporarily diverge. If the arbitrageurdoes not have access to additional capital when the security prices diverge, he maybe forced to prematurely unwind the position and incur a loss. The prospect ofincurring this loss will further limit the amount that a specialized arbitrageur iswilling to invest.

OPERATIONAL ISSUES

In situations where it is possible to exploit mispricing risklessly by generatingperfectly hedged positions and holding on to them till the final payoff, thefollowing operational aspects need be noted before entering into an arbitrage:

1. For the arbitrage to be a riskfree process, the arbitrageur must trade

simultaneously across two markets. In efficient markets, arbitrage opportunitieslast for very short periods. As arbitrageurs spot these opportunities andact upon them, the arbitrage gets wiped out. The fastest instances of arbitrageopportunities being wiped out are those seen in the foreign exchange market. Thismarket trades currency in large volumes, so what seems like a small mispricing canoften translate into huge profits.

Take the case of a trader sitting at a trading terminal of a bank in Mumbai. He seesthat Bank A quotes the US dollar at 48.5560 (i.e. it will buy dollars at Rs.48.55and sell dollars at Rs.48.60). At the same instant, Bank B offers a quote of 48.6570 (i.e. it will buy dollars at Rs.48.65 and sell dollars at Rs.48.70). The traderspots the arbitrage opportunity and simultaneously places two trades. He buysdollars at 48.60 from Bank A and sells them at 48.65 to Bank B making a profit ofRs.0.05 per dollar of trade. However, prices on the foreign exchange marketchange continuously. Had he not to place the trades simultaneously, he would facethe risk of price movements. Assume that he places the orders with a small lag, i.e.he first buys dollars at Rs. 48.60 from Bank A and a few seconds later, sells themat Bank B. However when he approaches Bank B, he realizes that in those fewseconds, Bank B has revised its quotes to 48.5055. The arbitrage has already been

wiped out. He is now stuck with dollars bought at 48.60 and faces the risk of afurther loss on the transaction.


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2. Trading involves transactions costs. These transactions costs and other marketimperfections create a noarbitrage band around the fair value of an asset. Hencethe arbitrage opportunity must be sizeable enough to generate a profit over andabove the costs involved. Not all mispricing are profitable arbitrage opportunities.Consider the case of hike in onion prices seen in India a few years ago. Onionstraded at about Rs.60, 000/ton in Delhi and at Rs.58, 000/ton in Nashik. Anarbitrageur could have earned a profit of Rs.2, 000 per ton by buying onions inNashik and selling them in Delhi. However the potential returns net oftransportation costs and other overheads were clearly not attractive enough forarbitrageurs to step in.

HISTORY OF ARBITRAGE IN INDIA

Arbitrage is not a new concept in India. Although the level of activity was notsignificant, market players have been engaging in intercity arbitrage for a longtime. A fairly high level of arbitrage activity was seen across the two largeexchanges in Bombay.

Line operators (Inter city)

In India, weve had over a decade of experience with multiple stock exchanges andline operators arbitraging between these markets. This has been a fairly wellaccepted idea. These arbitrageurs mostly operated between Bombay, Ahmedabad,Calcutta and Delhi. They used telephone lines & screens to locate the difference inprices. The main centres for arbitrage though were Bombay and Calcutta. Here ishow the arbitrage happened:

There were brokers who either had cards on both the exchanges, and alliances with

members of the other exchanges. By calling up the other exchange, the rates for astock, for example, Reliance or ACC were determined. Normally the difference inprices across exchanges would be about one to two percent. The stock would bepurchased on the exchange where it quoted at a cheaper price and sold on theexchange where it traded at a higher price. The settlement cycles of the exchangeswere different so the delivery that was received from one exchange could be given


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to the other exchange. If there was short delivery, the transaction would be carriedforward.

However, these operators suffered risks of settlement due to movement of stocksand funds across the country. The stocks had to be moved in the physical formbetween the two markets, and amongst other risks there was the risk of baddelivery. Due to the high risk involved in this operation, the returns were also high.The activity was limited to a few brokerage houses.

NSE-BSE Arbitrage trades

Trading Days NSE BSE

Tuesday Buy Reliance Sell Reliance

Wednesday Sell Reliance Buy Reliance

Friday Sell ACC Buy ACC

Monday Buy ACC Sell ACC


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NSEBSE (MANUAL TRADERS)

In the mid 90s NSE & BSE went electronic and moved over to screenbased trading. The period witnessed huge volumes due to arbitrage across theexchanges. The arbitrage process involved two people working as pairs. The pairsconcentrated on one or two scrips at a time. This process generated high returns,typically around 11.5 % per week. Here is how the arbitrage worked:

The settlement cycle at NSE was Wednesday to Tuesday and that at BSE wasMonday to Friday. Positions could be built up during the entire week, andunwound on the last day. The residual or the portion that was not unwound wouldgo for delivery. Since most of the traders did not have the funds or stocks to take orgive delivery, there would be a mad scramble to square off the transactions on

Tuesday and on Friday, the last date of settlement on the NSE and the BSE,respectively. During a typical week, traders would mostly have buy positionswhich they would want to square off. This would result in depressed prices at NSE.At the same time, the trader would want to maintain the buy position so he wouldbuy the same stock on the BSE. This would result in inflated prices on the BSE.The gap in prices of the same stock across NSE and BSE would be between halfpercent to two percent. The arbitrageur would now enter the scene. He would buythe stock where it traded cheap, i.e. on the NSE and sell it on the BSE where it wasmore expensive.On Wednesday, the arbitrageur would buy the same stock on the BSE and sell it

on the NSE for a modest return. The effect of this trade was that the BSE positionwas squared off on the BSE and no cross delivery of stock was required (Thismattered because ofbaddelivery problems which were rampant then). On Fridaythe entire process was repeated. The arbitrageur bought stocks on the BSE and soldthem on the NSE. On Monday, he would again buy at NSE and sell at BSE. Table1 shows the cycle as it typically happened. The net returns in a week would bebetween one to three percent depending on the markets.

Initially, the returns on the arbitrage across NSE and BSE were very high. These

returns attracted more participants. Competitive process led to humans and capitalbeing deployed into arbitrage. As the number of players in the game increased, thearbitrage was gradually wiped away and returns fell. The arbitrage activity acrossNSE and BSE is a classic example of how arbitrage helps to restore marketefficiency.


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With rolling settlement, this activity has lost its charm and the returns are verypoor. In the absence of a weekly settlement period, only intraday arbitrage ispossible. Sometimes the difference at the end of day is around one percent. Thedifficulty in arbitrage lies in competition.

When NSE first began its operations, the differences in prices between NSE andBSE were embarrassingly large price differences as large as Rs.10 wereoccasionally seen on Reliance at a base price of Rs.300.Today, it is rare to earnmore than Rs.0.25 on Reliance. This has happened because many now understandthe tricks of the trade for the NSE/BSE arbitrage, and the competition haseliminated the best opportunities. The game is now poised to shift to a higher anddifferent level. The arbitrageurs who were previously employed in this field havestarted to look at new areas where they can deploy their existing domainknowledge.

EXISTING ARBITRAGE OPPORTUNITIES

The launch of the derivative markets in India has given rise to a whole new worldof arbitrage. Multiple products with the same underlying asset are now availablefor trading. Mispricing across the spot, futures and options markets can led to

profitable arbitrage opportunities.

Dividend arbitrageAround dividend declaration time, the stock options market can sometimes pose aprofitable arbitrage opportunity. Let us look at how this works. We know that thestock price should decline by the dividend amount when the stock goes exdividend. In the following tables, we illustrate dividend arbitrage using the spotand options market on Reliance.

Reliance has declared a dividend of 47.50 percent for the year. Assume that on22nd October, just prior to the exdividend date, the stock trades at Rs.238. 31stOctober 240 puts trade at Rs.9. When the stock goes exdividend, the price ofReliance should drop by Rs.4.75 to Rs.233.25. Puts will now be worth at leastRs.6.75 (in addition to any remaining time value). A trader could exploit thissituation


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Table 1 Details of Reliance stock and puts:

PARTICULARS Rs.

Reliance Price 238

Reliance 240 put option premium 9

Next dividend net of tax 4.75

Table 2 Position of trader on Reliance before the stock goes exdividend:

POSITION Rs.

Long Reliance 238

Long Reliance 240 Put option 9

Total outlay 247

Table 3 Position of trader on Reliance after the stock goes exdividend:

POSITION Rs.

Long Reliance 233.5

Long Reliance 240 Put option 11.25

Dividend received 4.75


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Table 4 Cash flows of dividend arbitrage:

ACTIVITY Rs.

Buys Reliance (238)Buys Reliance Puts (9)

Sells Reliance 233.25Receives Dividend 4.75

Sells ABC puts 11.25

Total Profit 2.25

by buying the stock and buying put options at Rs.9. Table 2 gives the tradersposition before the stock goes exdividend and Table 3 gives his position afterthestock goes exdividend.

At this point, that is, after the stock goes exdividend, he sells the put option andthe stock. He has received a dividend of Rs.4.75. Thus his total revenue works outto be Rs.249.25. Table 4 gives the cash flows from his transactions. He makes arisk free arbitrage profit of Rs.2.25 on the initial outlay of Rs.247. This works outto a return of nearly one percent over one day.


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POTENTIAL ARBITRAGE OPPORTUNITIES IN EQUITY

MARKETS

IndexExchange Traded FundsExchange traded funds are innovative mutual fund products that provide exposureto an index or a basket of securities that trades on the exchange like a single stock.They have a number of advantages over traditional openended funds as they canbe bought and sold on the exchange at prices that are usually close to the actualintraday NAV of the scheme. They are an innovation to traditional mutualfunds as they provide investors with a fund that closely tracks the performance ofan index with the ability to buy/sell on an intraday basis. Unlike listed closedended funds that trade at substantial premium or more frequently at discounts toNAV, ETFs are structured in a manner which allows to create new units andredeem outstanding units directly with the fund, thereby ensuring that ETFstrade close to their actual NAVs.

ETFs came into existence in the US in 1993. Over $70 billion is invested in theETF market today. They have gained prominence over the last few years with over$100 billion invested as of end 2001 in about 200 ETFs globally. About 60% oftrading volumes on the American stock exchanges are from ETFs. Among thepopular ones are SPDRs (Spiders) based on the S&P 500 Index, QQQs (Cubes)

based on the Nasdaq-100 Index, iSHARES based on MSCI Indices and TRAHK(Tracks) based on the Hang Seng Index. Since the product underlying them is thesame, i.e., the index portfolio, this permits arbitrage between spot, futures andETFs. The same position can then be rolled over from one product to another inorder to maximize profits. All this requires robust IT systems and trained manpower. The human arbitrageur will find himself hopelessly out of depth if he has tocontinuously monitor a number of parameters.

At the moment however, both the index fund and the ETF market in India is veryyoung. We have a long way to go before arbitrageurs can actively enter this marketand make profits. But nonetheless it is a potentially promising market. The firstETF in India, Nifty BeEs(Nifty BenchmarkExchange Traded Scheme) based onS&P CNX Nifty, was launched in December 2001 by Benchmark MutualFund. It can be bought and sold like any other stock on NSE and has allcharacteristics of an index fund.


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ADR/GDRunderlying shares

In February 2001, the government allowed twoway fungibility of ADRs/GDRs. Ittook a full year for Reserve Bank of India to come out with guidelines on thisissue. On August 5th 2002, the first twoway fungibility deal was struck in India.With fungibility now functional, it opens new opportunities for arbitrage in theglobal equity arena.

In twoway fungibility, depository receipts can be converted into underlyingdomestic shares and local shares can be reconverted into depository receipts. Thedepository receipts could either be global depository receipts (GDRs) or AmericanDepository Receipts (ADRs). GDRs are listed on the London or the Luxembourg

stock exchange, while ADRs are listed on the US exchanges like the New YorkStock Exchange (NYSE) or the Nasdaq. Since every GDR/ADR has a givennumber of underlying shares, the number of shares qualifying for reconversioninto GDRs/ADRs is limited to the number of shares which were converted intolocal shares.

How can twoway fungibility help exploit equity arbitrage opportunities?Say for instance that the ADR/GDR price is at a discount to the price of the

underlying share. Converting the ADR/GDRs into the underlying shares can now

result in a gain. IF the ADR/GDR price is at a premium to the price of theunderlying shares, then it makes sense to reconvert the underlying shares intodepository receipts. All this is subject to headroom or the availability of shares forreconversion.Say for example a particular company has issued 10 million ADRs with one

underlying share per ADR. Two million ADRs have been reconverted into localshares. The outstanding number of ADRs is now 8million. However, the 2 millionADRs which were cancelled and converted to shares in the domesticmarket, can be reconverted to ADRs. Twoway fungibility is the first steptowards a truly global equity market for Indian equity. The final step would be a

free flow of equities between domestic and overseas exchanges.


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Globally listed stocks

With the globalisation of capital markets, increasing numbers of

companies over the world have chosen to raise capital through global equity issuesor are in the process for raising future capital by way of crosslistings on foreignexchanges. The crosslistings on exchanges across the world have opened newavenues for arbitrage. Just as Indian stocks get listed overseas, in the future, wewill find foreign companies seeking listings in India. This will allow arbitragebetween the two markets. This arbitrage could begin as a manual process, butovertime this process will have to be automated. Issues of FERA, settlement andcounter party risk will have to be addressed. When we move to capital accountconvertibility, Indian brokerage houses will have the option of starting overseasoperations which will enable them to arbitrage in the international markets.

Quantitative tradingThe world of quantitative trading is enveloped in secrecy with few having access toit. Unlike fundamental analysis, which relies largely on subjective or qualitativedata (such as the skill of a companys management), quantitative trading is basedon the study of the company(or a sector) using quantifiable data. Key ratios such aspricetosales, along with average analyst rankings are used for short listing

stocks.A quantitative analysis model might also throw in economic data,or compare how interest rates have affected a particular company or its sector inthe past. These techniques aim to capture the massive amounts of financialinformation flowing through our systems on a daily basis, analyzing andtransforming it to develop a disciplined, rigorous approach to portfolio investing.Quantitative techniques apply the latest tools and techniques in investmentmanagement and information technology to identify and exploit arbitrage arisingout of mispriced securities.

Brokerages and institutions have used quantitative modelling for years. There hasalways been a mystique surrounding it. The actual inputs into the model tend to beclosely guarded secrets. The models have been called black boxes, while themodels programmers have often been dubbedquants or rocket scientists, andkept holed up in back rooms. With the rapidly increasing availability of onlineinformation and growing computational power, quantitative trading is alreadya significant phenomenon globally.


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RISKS IN ARBITRAGE IN INDIA

The basic principles of an arbitrage strategy are straightforward if an asset tradesat two different prices across two markets, buy where it trades cheap and sellwhere it trades expensive. This project assumes a frictionless world wherearbitrage profits can be made without putting up capital and without bearing anyrisk. In reality however, almost all arbitrage requires capital and carries somerisk. These discrepancies become particularly important when arbitrageurs manageother peoples money. In India the risks become even more pronounced due toexisting market frictions.

Execution lagsIn the ideal world, trades placed to capture an arbitrage opportunity would beinstantaneously executed. However, in the real world, execution takes time. Veryoften, there can be variations in price between the time an arbitrage opportunity isentered into and the time the trade is actually executed on the market. Take forinstance the reversecashandcarry index arbitrage that we spoke about earlier.This involves buying the underpriced index futures and selling the overpriced

index basket. Typically, the futures market is more liquid than the spot and hencethe trade on the futures market would get executed instantly. However, the tradesinvolving the selling of the index basket on the cash market may not happeninstantly. There could be a slow down or halt in trading due to illiquidity or marketcongestion. This slippage naturally increases when markets are volatile. A highlyvolatile market would result in the index stocks being traded at different levels ofthe index. Hence, there is always some risk that the cash and futures legs of thearbitrage strategy may not be executed simultaneously. The risk is compoundedwhen the arbitrageur starts legging, that is when he starts taking a view onthe market in an effort to maximize the returns.


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Interest rate uncertainty

An arbitrageur who enters into an arbitrage trade assumes that a particular level of

interest rate will remain constant. In the cash

and

carry strategy, the arbitrageurassumes that he will be able to borrow at a certain rate till the expiration of thefutures contract. Similarly, in the reversecashandcarry strategy, he assumesthat he will be able to invest the proceeds from the sale of stocks at a particularrate of interest. However, the uncertainty about the interest rate that will becharged on the capital that is deployed and the returns that would be generatedfrom the free funds deployed in the money market, have a direct bearing on theprofits generated from arbitrage positions undertaken.

Trading restrictionsWhen the markets are very volatile, the stock exchange imposes a circuit breakeron the stocks. On NSEs market, whenever the index moves by 10, 15 or 20

percent in one day, NSEs rule comes into play which halts trading. These tradinghalts are coordinated by SEBI. At this point all trading on the exchange is stopped.The exchange allows the markets to process all the relevant information and cometo equilibrium. A halt in trading can result in a loss for an index arbitrageur who,as a part of his arbitrage strategy, is in the process of buying or selling the indexstocks.


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IMPEDIMENTS TO ARBITRAGE IN INDIA

Short sales constraints

Stock index futures normally trade at a premium to the cash index. The appearanceof a discount sends a strong signal that the futures may be underpriced. When astock index futures price is considered cheap relative to the stock index,arbitrageurs buy futures and short the stocks in the index.

A rich futures price triggers the reverse program, to short the futures and buy thestocks in the index. When one shorts the stock it is required that shares be availablefor delivery on the settlement date. If one does not have the shares, a strongborrowing/lending mechanism should allow for delivery using borrowed shares.This is absent in India at the moment. This makes going in for reverse cash andcarry difficult. Moreover, when intraday arbitrageurs forcibly close down theirposition in the evening they further force the futures into large discount. Tostrengthen arbitrage in the equity futures market, proper lending/borrowingmechanism should be evolved which can help in reducing the arbitrage gap.

Lack of liquidity and depth in the spot marketIndex arbitrage involves the buying or selling of all the index stocks in the cashmarket. This can be done by placing program trades. Due to lack of liquidity andproper depth in the capital market segment, trades on this segment do not getimplemented instantly. Although the constituent stocks of most indexes aretypically liquid, liquidity differs across stocks. These factors often make arbitrageexpensive, risky and difficult to implement.

Many stocks within an index have small share price values. When purchasing anindex, the goal is to obtain a Rupee amount of investment. Small price stocksrequire more individual shares to be purchased for a given Rupee value of indexexposure. This increases the execution costs. Because some stocks in an index areless liquid than others, the mandate to buy all stocks within the index creates aninefficient pool of stocks. Stocks with less liquidity create higher invisible tradingcosts (bidask spreads)


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Capital intensive nature of arbitrage

Realworld arbitrage requires putting up huge capital for a short period of time.

Take the case ofcash and carry arbitrage. In order to capture the mispricing, thearbitrageur sells the overpriced futures, buys the underlying stocks and holds themtill the maturity of the futures contract. Buying the underlying stock requires hugeamount of capital. Very often due to lack of capital, it is not possible for thearbitrageur to take delivery and hold stocks. Hence small arbitrageurs are forcedinto intra-day arbitrage.

Arbitrage hinges on capturing profits due to mispricing on the market. Theunderlying assumption is that at some stage the mispricing will be wiped out andprices will return to their fair value. This is when the arbitrageur receives his

profits. However it may often happen that prices do not correct themselvesimmediately. There could be situations where the mispricing worsens, in whichcase the arbitrageur would be required to bring in more capital by way of margins.Even if eventually the prices of the two contracts converge and the arbitrageurmakes money, in the short run he loses money and needs more capital.Arbitrageurs face difficulties in raising funds at short notice. Very often anarbitrage strategy that is entered into is reversed before the end of the contract.This is known as early unwind.

Anomalies in regulation and taxation of arbitrage trades

In India, from the regulatory and taxation point of view, trades undertaken toexploit arbitrage are still regarded as speculative trades. This increases transactionscost on arbitrage and impedes the development of arbitrage in India.

Absence of hedge fundsHedge funds are among the most active participants in the arbitrage game. Mosthedge funds have schemes which involve engaging in purely arbitrage transactions.In the absence of proper hedge funds regulations in India, there is very little hedgefund activity in India.


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CONCLUSION

Arbitrage is a fascinating process. Theoretically, an arbitrage opportunity is likemoney lying on the road waiting to be picked. The trick of the trade is in beingable to spot the opportunity quickly. Besides an understanding of the markets, theprocesses and the risks involved, exploiting arbitrage also requires capital andinfrastructure. In some markets it is possible to detect and capture arbitrage profitsmanually. Doing an arbitrage trade today is fairly simple. However, as derivativesget more complicated, the procedures employed for doing arbitrage will steadilyget more complex. This will require new skills to be developed and new processesto be formulated. With the introduction of multiple new products, faster trading

mechanisms and more efficient markets, it may prove to be impossible for thehuman eye to detect or act upon arbitrage. We would then have to rely oncomputers. As computers get into the game, hedging, speculating & arbitrageopportunities would be quickly wiped out.

There would however always be smart operators who would find ways to use newproducts and new markets in order to continue the arbitrage ,speculating & hedginggame in the equity markets.


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BIBLIOGRAPHY

www.wikipedia.com www.investopedia.com www.nseindia.com www.bseindia.com
http://www.wikipedia.com/http://www.wikipedia.com/http://www.investopedia.com/http://www.investopedia.com/http://www.nseindia.com/http://www.nseindia.com/http://www.bseindia.com/http://www.bseindia.com/http://www.bseindia.com/http://www.nseindia.com/http://www.investopedia.com/http://www.wikipedia.com/

bhavisha prjkt

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