It is well known that arbitrage funds make money from low-risk buy-and-sell opportunities available in the cash and futures market. But how do arbitrage funds cope when a top stock exchange witnesses trading halt, as NSE did in second week of July?
Do they close their systems and wait for things to resume? What is their back up plan to deal with such unforeseen events where cash market quotes were erroneous, throwing up discrepancies between cash and derivatives prices? Value Research spoke to some top fund managers to understand the situation.
The idea of this article is not to look into trading halt itself or the reasons behind it; but at the arbitrage fund investors' point of view. The nature of arbitrage trades means opportunities vanish in moments unless you can capture them by trading. The logical approach could be to go to another exchange to finish the trades, but what is logical is not always practical.
Multi pronged strategy
Sunil Singhania, CIO - Equity Investments, Reliance Mutual Fund, explains that arbitrage fund buy/sell stock in NSE and BSE and long/short future of underlying security on NSE and earns the spread between them.
If NSE cash segment is not open for a complete day then cash leg for arbitrage can be executed on BSE against which futures leg would be executed on NSE.
"If NSE futures segment is also not open for a complete day, then cash leg for arbitrage can be executed on BSE as well as futures would also be executed on BSE. Since BSE derivative segment is practically non-existent, in case of non-availability of NSE futures for trading, arbitrage activity for the day would be halted," Singhania says.
If NSE futures segment is not open for the complete day on an expiry day, then the existing derivative contracts would not have expired. "We would not be able to roll them over to the next month and this would have impacted the scheme's returns. In such a scenario, expiry date of existing contract needs to be extended," the top investment professional from Reliance MF said.
It is also important for investors to understand that in arbitrage funds the transaction orders of the same quantity are executed simultaneously in the spot and future segments in a one to one correlation. The positions are thus fully hedged and such events do not result in any trading risk in the portfolio.
Some arbitrage funds choose to take a more conservative approach to trading on days of outage and wait for systems to restart and stabilize with the stock exchanges before entering any new orders.
Avoiding some bets
"The trading desk monitors the price difference between the spot and futures market on a real time basis and is well positioned to exploit any arbitrage opportunities available on days of market disruptions," says a senior investment professional at a mid-sized fund-house, who requested anonymity.
Many arbitrage funds, however, do not go after intra-day mispricing opportunities and may not be really concerned with such anomalies. But normal functioning of cash and equity derivatives are still important.
Ashwin Patni, Head - Products and fund manager, Axis MF, said: "Arbitrage funds are predominantly focused on capturing cash and carry arbitrage in stocks and futures. This is achieved by taking a long position in a company's stock and a corresponding short position in its future to capture the spread between the two. It is to be noted that these spreads by and large tend to be quite stable through a trading day and that the typical holding period of these trades is close to a month (since stock futures have a monthly expiry). These funds typically do not focus on intra-day mispricing opportunities (such as between exchanges), which are more looked at by proprietary traders," he says.
Patni, however, concedes that for arbitrage funds it is crucial that cash equity and derivative markets are operating seamlessly since cash and carry arbitrage trades need to be fully covered in order to ensure that there is no directional exposure created on any stock.