Instruments: Attractive Arbitrage And Investment Opportunities

Arbitrage is a trading strategy that involves taking advantage of price differences for the same or similar assets in different markets. It is a widely used and ancient trading strategy that relies on market inefficiencies to turn a profit. Arbitrageurs, as they are known, will buy an asset in one market and sell it in another, profiting from the price difference. This strategy is often used in stocks, commodities, and currencies, but it can be applied to any asset class. Arbitrage funds, for example, are a type of mutual fund that aims to profit from price discrepancies in different markets or instruments. They are considered low-risk investments that can provide stable returns, making them attractive to investors seeking a balance of returns and risk mitigation.

Low-risk investments

• High-yield savings accounts: Savings accounts offer a modest return on your money, with the highest-yielding options available online. They are completely safe in the sense that you'll never lose money, and most accounts are government-insured up to a certain amount per account type per bank.
• Money market funds: Money market funds are mutual funds that pool together CDs, short-term bonds, and other low-risk investments to diversify risk. They pay out cash interest on a regular schedule, usually monthly, and are pretty safe.
• Short-term certificates of deposit (CDs): CDs are always loss-proof in a backed account, unless you take the money out early. Short-term CDs offer better liquidity than longer-term options, and rates remain attractive even if interest rates are lowered.
• Cash management accounts: These accounts can be used as checking accounts and savings accounts, and they may offer competitive interest rates without charging fees.
• Treasurys and TIPS: These are highly liquid securities that can be bought and sold directly or through mutual funds. If you keep Treasurys until they mature, you generally won't lose money. TIPS are securities whose principal value goes up or down depending on the direction of inflation.
• Dividend-paying stocks: Stocks that pay dividends are generally perceived as less risky than those that don't. Dividend-paying companies tend to be more stable and mature, and they offer the possibility of stock price appreciation.
• Money market accounts: These accounts may require a higher minimum deposit than savings accounts but offer higher interest rates. They are protected by the FDIC, with guarantees up to a certain amount per depositor per bank.
• Fixed annuities: Annuities are contracts that provide a guaranteed level of income over some time in exchange for an upfront payment. Fixed annuities can provide a guaranteed income and return, giving you greater financial security, especially during periods when you are no longer working.
• U.S. Treasury Bills, Notes, and Bonds: U.S. Treasury securities are backed by the full faith and credit of the U.S. government, which has always paid its debts. There are various maturities available, with Treasury notes and bonds carrying slightly more risk than shorter-duration securities.
• Series I Savings Bonds: I bonds are a special type of U.S. savings bond with a variable interest rate designed to keep up with inflation. They offer returns based on a fixed rate and a variable interest rate that is updated to match the prevailing rate of inflation.
• Treasury Inflation-Protected Securities (TIPS): TIPS are issued by the U.S. Treasury and use a mechanism to ensure returns keep up with the rate of inflation. They offer maturities of five, ten, or thirty years, with a fixed rate of interest.
• Investment-Grade Corporate Bonds: Corporate bonds are fixed-income securities issued by public companies with a very good credit rating. Credit rating agencies assign ratings to companies after researching their finances and stability.
• Preferred Stocks: Preferred stocks combine the characteristics of stocks and bonds, providing investors with dependable income payments and the potential for shares to appreciate over time.

Steady returns

The potential for steady returns is a key advantage of arbitrage funds. Arbitrage is a trading strategy that exploits price differences in the same or similar assets across different markets. By simultaneously buying an asset in one market and selling it in another, arbitrageurs can profit from the temporary price imbalance. This strategy is particularly effective in volatile markets, where short-term price inefficiencies are more common.

Arbitrage funds are a type of mutual fund that aims to generate steady returns by capitalising on these price discrepancies. They are considered low-risk investments because they focus on taking advantage of price differences rather than market direction. The returns are also comparatively less volatile than those of pure equity funds.

The fund manager of an arbitrage fund plays a crucial role in identifying arbitrage opportunities and executing trades to capture the price differences. When there is a scarcity of attractive arbitrage deals, these funds may increase their investment in debt instruments, which are generally seen as stable investments.

While the returns from arbitrage funds may not be spectacular, they can offer consistent, positive returns, making them appealing to investors seeking predictable income streams. Additionally, arbitrage funds are categorised as equity funds for taxation purposes, which translates to better tax benefits compared to debt funds.

Overall, the potential for steady returns makes arbitrage funds an attractive investment option, particularly for those seeking stability and low risk in their investment portfolios.

Tax advantages

Reduced Tax Liability

The primary benefit of tax advantages is the potential for reduced tax liability. This can take various forms, such as tax credits, deductions, or exemptions. For example, investors can benefit from tax savings under specific sections of tax codes, such as Section 80C in India, which allows for substantial tax reductions.

Tax-Free Investments

Some investments may offer tax-free status, meaning that investors are not required to pay taxes on the income generated from those investments. For instance, dividends received from certain investments may be exempt from taxation.

Deferred Taxation

Certain investment vehicles allow investors to defer taxation until a later date. This can be achieved through tax-deferred accounts, such as retirement plans, where taxes are only paid upon withdrawal during retirement.

Lower Tax Rates on Long-Term Gains

Many tax systems differentiate between short-term and long-term capital gains, with long-term gains benefiting from lower tax rates. Investments that are held for the long term can, therefore, result in reduced tax liability.

Tax Benefits for Specific Groups

Some tax advantages are targeted towards specific groups, such as senior citizens or individuals in certain industries. These advantages can include tax deductions, credits, or preferential tax rates, making certain investments more attractive to these groups.

Tax Arbitrage

Tax arbitrage involves taking advantage of differences in tax rates or regulations between two or more markets or jurisdictions. By engaging in simultaneous buying and selling of similar assets in different markets, investors can profit from the price discrepancies, including any tax-related differences.

Enhanced Returns

Risk Mitigation

Exploiting market inefficiencies

Arbitrage is a trading strategy that exploits market inefficiencies, specifically price differences for identical or similar assets in different markets. For example, a trader might buy shares of Company X on the NYSE, where they are trading at $20, and simultaneously sell the same number of shares on the LSE, where they are trading at $20.05, thereby profiting 5 cents per share.

The act of arbitraging brings markets closer to efficiency by exploiting and resolving these short-lived variations in price. Arbitrageurs, as they are called, usually work on behalf of large financial institutions, and trades often involve substantial amounts of money. Arbitrage opportunities are typically identified and acted upon with highly sophisticated software.

Arbitrage can be applied to any asset class but is most commonly used in liquid markets such as commodity futures, well-known stocks, or major forex pairs. These assets can often be transacted in multiple markets at once, creating opportunities for purchasing in one market and selling in another simultaneously to take advantage of price discrepancies.

The strategy is particularly effective in volatile markets, where short-term price inefficiencies are more common. Arbitrage funds, for instance, are a type of mutual fund that aims to exploit these price differentials. They are considered low-risk investments because they seek to take advantage of price discrepancies rather than market direction.

However, arbitrage opportunities are not always readily available, and the returns can be unpredictable. Additionally, the price differences are usually very small, so arbitrage fund managers need to make several trades in a day to book a reasonable profit. This strategy is also associated with high expense ratios due to the active management required to identify and capitalise on arbitrage opportunities.

Despite these challenges, arbitrage remains an attractive strategy for investors due to its potential for steady returns and low-risk profile. It is a unique approach that combines equity's growth potential with hedging techniques to minimise risk.

Profiting from price differences

Arbitrage trades are most commonly made in stocks, commodities, and currencies, but they can be accomplished with any asset type. Arbitrage provides a mechanism to ensure that prices do not deviate substantially from their fair value for long periods. With advancements in technology, it has become increasingly challenging to profit from pricing errors in the market. Many traders use computerized trading systems to monitor fluctuations in similar financial instruments, and any inefficient pricing setups are usually acted upon quickly, often in a matter of seconds.

Imagine that the stock of Company X is trading at $20 on the New York Stock Exchange (NYSE), while simultaneously trading at $20.05 on the London Stock Exchange (LSE). A trader can buy the stock on the NYSE and immediately sell the same shares on the LSE, earning a profit of 5 cents per share. The trader can continue to exploit this arbitrage until specialists on the NYSE run out of Company X's stock or until specialists on either exchange adjust their prices to eliminate the opportunity.

Arbitrage funds are a type of mutual fund that aims to exploit these price differentials in different markets or instruments to generate returns. These funds are considered low-risk investments. They are a type of hybrid fund, holding a mix of equity (stocks) and debt instruments (for short-term parking of money). Arbitrage funds deal with stocks and are technically classified as hybrid funds, but their low-risk profile makes them more attractive to investors seeking stability compared to traditional equity funds.

An arbitrage fund manager identifies a security or asset, such as shares of XYZ Ltd., trading at different prices in the cash market (spot) and the derivatives market (futures and options). For example, shares of XYZ Ltd. are trading at Rs. 100 in the spot market and Rs. 105 in the futures market for a one-month contract. The fund manager then performs two actions simultaneously:

• Buy the stock in the cash market (lower price).
• Sell an equivalent amount of futures contracts for the same stock (higher price).

By buying low in the cash market and selling high in the futures market, the fund creates a risk-free position and locks in a profit of Rs. 5 per share (Rs. 105 - Rs. 100).

Frequently asked questions