Domestic Arbitrage

Domestic Arbitrage exits between the difference in prices in the cash and futures markets. When you take positions in the cash market you have to either pay or give deliveries at the end of the day for any outstanding position. The position you take in the futures market can be carried forward till the expiry of the contract on the last Thursday of the month (see derivatives section for more information). The person who buys or sells shares in the futures market only pays a margin of between 20-40% (in normal times) of the total value of the position so is getting leverage on the position that he is taking.
Therefore in times of bullishness investors are willing to pay a slight premium to the underlying cash price in the futures market as they expect the stock to rise in the short term and are willing to pay the premium (discounts do also happen at times of dividend and bearishness in the stocks and thus no arbitrage would exist unless one previously held the underlying stock).
For example if Reliance is trading at Rs.500 in the cash market, at the beginning of the new futures contract it may be trading at Rs.505. The investor who buys at Rs.505 has the full month to hold the position and has the option to roll it over to the next month at any time before expiry.
The arbitrageur to take advantage of this buys Reliance in the cash market and simultaneously sells in the futures market locking in a profit of Rs.5 (before charges). Whether the price of the stock moves up or down he is secured with his return. In the normal course of events the gap decreases towards the end of the month and the arbitrageur will either reverse the position in both markets or rollover the futures position to the next month if the new gap is acceptable to him. The return is calculated on the amount of funds deployed for the fixed time period to expiry. If the gaps comes down before expiry the arbitrageur can exit the position and enter into a new stock where the gap is better.
Brokerages on the above are charged differently (lower than normal trading brokerages) due to the small spreads and are dependent on volumes. Minimum amount should be Rs.10 lacs due to the high value of futures contracts. Margins have to be paid in addition to the investment made in the cash market which must also be factored in when calculating returns.
This is a risk free investment which suits investors who have idle funds in bank fixed deposits as one should expect a taxable return of 12-18% per annum as per the recent past and market outlook. If returns dip the investor can take his funds back within 3 days. Investors must take advice from their accountants on the tax implications on this type of trading.
The above is a general overview of the process and for more detailed information please contact us.