What are Arbitrage Funds?

Arbitrage funds are a type of mutual fund. They earn money from price differences in the market. They use price gaps between the cash market and the derivatives market.

Stock funds bet on the market’s direction. But arbitrage funds stay neutral. This makes them good for careful people who want steady earnings.

“Arbitrage” means buying and selling the same asset at the same time in different markets. This locks in a profit. SEBI rules say arbitrage funds must use this plan. They must also hold a certain amount in stocks.

How Do Arbitrage Funds Work?

Cash Market and Futures Market Strategy

Arbitrage funds use price differences between the cash market and the futures market. Fund managers watch for when the same stock has different prices.

When this happens, the fund buys and sells at the same time. This locks in a low-risk profit.

The cash market is for trades that happen now. The futures market is for trades at a set price in the future. This time gap creates price differences.

Simultaneous Buy and Sell Transactions

The fund buys a stock in the cash market at a low price. At the same time, it sells the stock in the futures market at a high price.

Doing both trades at once removes market risk. The fund’s spots are hedged. This means the profit is locked in, no matter how the market moves.

Price Differential Exploitation Process

Fund managers use computers to find small price differences. Each profit is tiny. So, the funds make many trades every day. The fund’s total earnings come from adding up these small profits.

Equity-Oriented Hybrid Fund Classification

SEBI rules say arbitrage funds must hold at least 65% of their money in stocks. This makes them a type of stock-focused fund. This gives them the same tax savings as stock funds.

Arbitrage Fund Investment Strategy and Performance

Risk-Free Profit Generation Mechanism

Arbitrage profits are low-risk because the fund’s spots are hedged. The fund holds both a buy and a sell spot in the same stock. This protects it from market swings. This makes it different from a stock or debt fund.

Portfolio Allocation in Arbitrage Funds

Minimum 65% Equity Allocation Requirement

At least 65% of the fund must be in stocks. This is mostly through the hedged spots used for arbitrage. If there are few arbitrage chances, the fund can invest the rest in debt.

Debt Securities for Surplus Capital

When arbitrage chances are low, managers invest the extra money in short-term debt. This includes things like government bonds. This keeps the fund steady and the money working.

Low-Risk Investment Characteristics

Arbitrage funds have lower price swings than stock funds. This is because they stay neutral to the market. Hedging lowers the risk of losing money.

But these funds are not risk-free. They face other risks. This includes trouble selling, interest rate changes, and working risks.

Performance in Volatile Market Conditions

Market Volatility and Arbitrage Opportunities

More market swings usually mean more arbitrage chances. Price gaps between cash and futures markets get wider. In wild markets, these funds often do better than debt funds.

Returns Compared to Traditional Debt Funds

Arbitrage funds have given earnings that beat other safe funds and bank savings. They also have better tax savings.

Tax Efficiency of Arbitrage Funds

Short-Term Capital Gains Taxation Benefits

Arbitrage funds are taxed like stock funds. Profits from investments held less than one year are taxed at a good rate. This is better than some funds where profits are taxed at your income tax rate.

Long-Term Capital Gains Tax Advantages

Profits from investments held more than one year also get good tax treatment. This includes a yearly tax-free limit. This gives them a big edge over debt funds after taxes. This is very true for people in high tax groups.

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