Arbitrage basics

In simple terms

Arbitrage means exploiting a price difference between two things that should be worth the same, by buying the cheaper one and selling the dearer one at the same time. In theory, when the prices come back together, the profit is locked in regardless of which way the market moves.

In practice, true arbitrage is rare, small and competitive, and many things called "arbitrage" carry real risks.

Cash-futures arbitrage

A future should trade near its fair value, the spot price plus the cost of carry, as the basis lesson explains. If it trades above that, a trader can:

1. Buy the shares in the cash market.
2. Sell the future at the same time.
3. At expiry, the future converges to the spot price. Close both legs; the gap at the start is the gross profit, whatever the share price does.

Why it is not truly risk-free

• Execution risk: the two legs may not fill at the intended prices at the same time; prices can move between orders, as the slippage lesson explains.
• Margin calls: if the share rises, the short future loses daily and must be paid in cash, while the gain on the shares is not cash until sold, as the futures margin lesson explains.
• Funding risk: borrowing costs can change.
• Dividends and corporate actions: an unexpected dividend, bonus or split changes the calculation.
• Settlement and rule changes: exchange rules, taxes and margin requirements change over time.
• Liquidity at expiry: closing large positions can move prices.

Why profits are small

Banks, brokers and specialist firms run arbitrage at large scale, with low costs, cheap funding and fast systems. Whenever a gap appears, they compete to close it, so the spread available after costs is usually small. An individual with higher costs and slower execution is at a disadvantage.

Arbitrage as a marketing word

"Arbitrage" is sometimes used to sell schemes promising high, steady, "risk-free" returns. Be very cautious:

• Genuine arbitrage returns are usually close to short-term interest rates, not far above them.
• Promised high fixed returns are a hallmark of fraud, as the recognising scams lesson explains.
• Strategies that are "risk-free until they are not" often hide leverage or tail risk, as the buyers and sellers lesson discusses.

Some mutual funds run cash-futures arbitrage as a strategy. Their returns vary with market conditions, and they carry the risks above, though managed at scale.

Why it matters

Understanding arbitrage explains why futures stay close to fair value, why spreads are small, and why claims of risk-free high returns should trigger scepticism rather than excitement.

Limitations

The example uses made-up prices and assumed costs and ignores taxes. Real arbitrage involves detailed knowledge of contract specifications, margin rules and costs that change over time.

Common mistakes

• Believing arbitrage is risk-free.
• Ignoring funding and trading costs.
• Forgetting cash needs for margin calls on the futures leg.
• Trusting high "arbitrage" returns promised by unregistered people.

Try it yourself

1. For a share at ₹500 and a 30-day future at ₹505, calculate the gross spread, funding cost at 7% a year, and net profit after ₹1.50 of costs.
2. Calculate how much cash would be needed for margin if the share rose 10% during the month on a made-up lot of 1,000.
3. Write down three questions to ask anyone promising risk-free arbitrage returns.