Definition of Arbitrage Fund
An Arbitrage Fund is a type of mutual fund that leverages the price difference of securities between two or more markets to generate low-risk returns. It primarily invests in equities and simultaneously takes offsetting positions in the cash and derivatives markets, aiming to benefit from market inefficiencies while minimizing risk.
Meaning of Arbitrage Fund in Detail
Arbitrage Funds belong to the hybrid mutual fund category and use the strategy of arbitrage trading—buying a stock in one market and selling it in another at a higher price. These funds capitalize on short-term mispricing in the equity markets.
For example, if shares of Company X are trading at ₹1,000 in the cash market but at ₹1,020 in the futures market, an arbitrage fund manager will buy shares in the cash market and simultaneously sell futures, locking in a risk-free profit of ₹20 per share.
These funds are popular among investors who want low-risk, tax-efficient returns and serve as an alternative to traditional debt funds.
Concept Breakdown
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Category: Hybrid Mutual Fund
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Primary Asset: Equity and equity-related instruments
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Strategy: Exploiting mispricing in cash vs. derivative markets
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Risk Profile: Low (market-neutral positions)
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Taxation: Taxed like equity funds (short-term: 15%, long-term: 10% after 1 year)
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Investor Profile: Conservative to moderate investors seeking safe returns
Formula / Calculation
The arbitrage fund profit can be calculated as:
Arbitrage Profit = (Futures Price – Spot Price) – Transaction Costs
Where,
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Futures Price = Price of security in the futures market
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Spot Price = Price of security in the cash (equity) market
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Transaction Costs = Brokerage, taxes, and other costs
Example Calculation
Suppose:
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Spot Price of Stock A = ₹1,000
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Futures Price of Stock A = ₹1,020
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Transaction Costs = ₹2
Arbitrage Profit = (1,020 – 1,000) – 2 = ₹18 per share
If the fund invests in 10,000 shares:
Total Profit = 10,000 × 18 = ₹1,80,000
Key Features of Arbitrage Funds
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Market Neutral: Profits do not depend on market direction.
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Low Risk: Hedged positions reduce volatility.
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Tax Efficiency: Taxed like equity funds, favorable compared to debt funds.
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Liquidity: Most funds allow redemption within T+2 working days.
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Short-Term Investment Option: Suitable for investors seeking safe returns for 3–12 months.
Importance / Role in Business
Arbitrage funds play an important role by:
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Offering stable returns to businesses and individuals.
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Acting as an alternative to fixed deposits or liquid funds for short-term surplus money.
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Helping companies manage treasury operations more effectively.
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Providing diversification in investment portfolios.
Advantages and Disadvantages
Advantages:
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Safer than equity investments
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Tax-efficient returns
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Suitable during volatile markets
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Low correlation with stock market trends
Disadvantages:
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Returns may be lower compared to equity or debt funds
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Profits depend on arbitrage opportunities (limited in stable markets)
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Short-term capital gains taxed at 15%
Usage of Arbitrage Funds
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Individuals: To park idle money safely with better tax treatment.
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Businesses: For treasury management and short-term liquidity needs.
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Institutional Investors: To balance risk in volatile equity markets.
Case Study Example
During 2018 market volatility in India, arbitrage funds became popular as investors sought safe alternatives to debt funds (which faced credit risks due to NBFC defaults). Large corporates invested surplus cash in arbitrage funds, benefiting from high volatility-driven arbitrage opportunities.
Practical Example
Imagine you have ₹5 lakhs to invest for 6 months. Instead of keeping it in a savings account earning ~3% annually, investing in an arbitrage fund could give you 5–6% annualized, post-tax, with almost the same level of risk.
Common Mistakes or Misunderstandings
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Believing arbitrage funds always give high returns (they don’t in stable markets).
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Considering them risk-free (market and liquidity risks still exist).
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Confusing them with hedge funds (different strategies and regulations).
Real-Life Applications
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Used by corporates for treasury investments.
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Preferred by conservative investors during volatile equity cycles.
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Beneficial in high-interest rate environments, where arbitrage spreads are higher.
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Regulated under SEBI’s Mutual Fund Guidelines in India.
FAQs
Q1: Are arbitrage funds safe?
Yes, they are relatively safe because they use hedging strategies, but returns depend on market volatility.
Q2: How are arbitrage funds taxed in India?
They are taxed as equity funds—15% on short-term (less than 1 year) and 10% on long-term (more than 1 year, above ₹1 lakh).
Q3: Who should invest in arbitrage funds?
Investors seeking safe, tax-efficient returns for the short term (3–12 months).
Q4: What is the minimum investment in arbitrage funds?
It varies by fund house but typically starts from ₹500–₹5,000.
Expert Tip from Learn with Manika
If you are holding idle cash for a few months, consider Arbitrage Funds instead of Fixed Deposits. They provide better post-tax returns with comparable safety, especially in volatile markets.
Related Terms
- Hedge Fund
- Derivatives Market
- Futures and Options
- Debt Mutual Fund
- Treasury Management
- Risk Arbitrage