Betaal the little ghost was watching Vikram cross the jungle path and finding an opportune moment he flew and perched upon his broad shoulders.
Explain Arbitrage Fund, “he said”. “Explain the concept of “Arbitrage” in as simple a manner as possible so that I have no doubts after listening to you. If you can’t explain it simply enough and if I am still troubled by “Arbitrage” concept, I’ll smash your head.”
Vikram remained unfazed as ever. Never to be troubled by such empty threats but always open to challenges.
“Ok Betaal. Let me explain the arbitrage concept to you with an example
Let us say tea is sold at the tea stall on the roadside for Rs 10 but for Rs 15 on the 10th floor canteen.
This means a price differential exists between these two markets ( roadside and 10th floor)
This price difference is an arbitrage opportunity.
Now a smart fellow can buy tea on the road for Rs 10 and sell it at 15 and make a clean profit of Rs 5.
But as customers come to know about this price difference they will start going to road side stall
if the tea vendor comes to know about the price of tea on the 15th floor he too will be tempted to raise his price.
So over a period of time this price differential can reduce or disappear.
Now let us see how Arbitrage is played out in the stock markets.
You must know that there are two markets. One is the spot market and the other is the futures market.
A difference in prices exist between these two markets as well.
The same stock will have a one price in the spot market and a different one in the futures market.
Let’s say the price is Rs 100 in spot market and Rs 11o in futures market.
Now let us assume I buy in spot market for Rs 100 and I sell in the futures market for Rs 110.
We must also know that towards the end of every month the prices of spot market and futures market will become equal.
On the expiry date all deals are “squared off” or “reconciled” or “hisab kitab” is done
Let us say the spot price rose from 100 to 105 on the date of expiry.
Therefore the futures price would come down from 11o to 105
(Since at expiry the common price was 105)
Clearly in spot market I made a Rs 5 profit (since I had bought at Rs 100)
And in the futures also I made a profit of Rs 5 (since I had sold at Rs 110 and now I can buy at 105 while squaring off)
Thus the total profit is Rs 5 + Rs 5 = Rs 10 ( the same difference that existed between spot and futures on the day I had done the arbitrage transaction)
This is the concept on which the Arbitrage Fund operates
Arbitrage Funds have given returns which would be around the returns of liquid fund.
But one needs to note that Arbitrage Funds are treated as Equity Funds and not taxed like debt funds.
This means like other Equity Funds, all dividends are tax-free and any capital gains is taxed at only 15% within the first year and is tax free thereafter.
If you are looking at a short term investment of less than one year, invest in the dividend re-investment option. so that the NAV does not rise much which makes capital gains miniscule.
So for a short-term investment of say 7 months, this is a good fund and even better than liquid fund because of the tax treatment.”
Vikramaditya finished and looked at Betaal.
“Now little ghost, hope you are clear about the concept of “Arbitrage” and the “Arbitrage fund”.
Betaal smiled at Vikramaditya and said,”nobody other than you could have explained this in a more lucid manner. So I am sparing again but will meet you another day with another query”
Saying this the Betaal took flight and disappeared into the thick forest as Vikramaditya continued his walk nonchalantly.