Arbitrage Strategy: Making Risk-Free Profits

The arbitrage concept works on the mispricing of assets across different markets due to the underlying inefficiencies in market pricing. In the derivatives segment, the market provides opportunities to derive returns from the implied cost-of-carry between the underlying cash market and the derivatives market.

Aug 17, 2018 03:08 IST IIFL Derivative Desk Raushan Kumar |

In the stock markets, arbitrage opportunities exist across the cash (delivery) and the derivative (F&O) markets. The arbitrage concept works off on the mispricing of assets across different markets due to the underlying inefficiencies in market pricing. In the derivatives segment, the market provides opportunities to derive returns from the implied cost-of-carry between the underlying cash market and the derivatives market. This provides for opportunities to generate returns that are possibly higher than short-term interest rates with minimal active price risk on equities. Implied cost-of-carry and spread across the spot and futures markets can potentially lead to profitable opportunities.
 
The strategies are:
 
1. Put-Call Parity: In options trading, the opportunities can appear when options are mispriced or put-call parity isn't correctly preserved. The principle of put-call parity was first identified by Hans Stoll in a paper written in 1969, “The Relation Between Put and Call Prices”. When put-call parity is correctly in place, then arbitrage would not be possible. But if not, then use "conversion and reversal arbitrage" and ”box spread".
 
2. Cash Future Arbitrage: It can be employed when the price of the future exceeds the price of the underlying stock. Buy the stock in the cash market and sell the future to lock the spread.  
 
3. ADR/GDR - Underlying shares: The depository receipts could either be global depository receipts (GDRs) or American Depository Receipts (ADRs). GDRs are listed on the London or the Luxembourg Stock Exchange, while ADRs are listed on the US exchanges like the New York Stock Exchange (NYSE) or the Nasdaq. Since every GDR/ADR has a given number of underlying shares, the number of shares qualifying for re-conversion into GDRs/ADRs is limited to the number of shares which were converted into local shares. 
 
If the ADR/GDR price is at discount to the price of the underlying share, converting the ADR/GDR into the underlying can result in gain and vice versa. The arbitrage opportunity could also be in the price spread between the different exchanges, such as BSE-NYSE, BSE-Luxembourg, or the other exchanges like Singapore, Australian, and European, where many of the companies trade. 
 
In simple words, if “HDFCBANK GDR” is trading at a discount, one can go long in GDR and simultaneously short future in the domestic market at higher prices. It will then require to convert the GDR into local shares and square off the future position in the local market. In the case of underlying share trading at a premium in the international market, one can borrow and go short in the international market, while simultaneously going long in the local market. It will then require converting the local share into GDR/ADR and canceling the borrowed position.
 
4. Corporate Action /Event-Driven Strategies: Any corporate action or event-driven strategy where there is a potential opportunity for arbitrage in cash and derivative markets such as:
  • Dividend Arbitrage: Around dividend declaration time, the stock futures/options market can provide a profitable opportunity. 
  • Buy-Back Arbitrage: When the company announces the buy-back of its own shares, there could be opportunities due to price differential in buyback price and trade price. For example, the TCS buy-back.
  • Merger: When the company any merger, amalgamation, hive off, de-merger, etc., there could be opportunities due to price differential in the cash and the derivative market.
 
Remarks

The key factors to aim for in arbitrage opportunities is 'perfect' execution, the transaction cost, and the liquidity in the stock's cash and futures segments. And for ADR/GDR arbitrage, only non-residents or FIIs are allowed to trade in these instruments and the retail investor cannot participate. Hedge funds, FIIs, and domestic arbitrage funds are very active in arbitrage strategy. But corporate action/event-driven strategies and cash future arbitrage are very useful for traders and long investors, but must be done under a derivatives experts' supervision. 

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