ARBITRAGE: UNDER-PRICED FUTURES.
BUY FUTURES. SELL SPDT
Whenever the futures price deviates substantially from its fair value, arbitrage opportunities arise. It could be the case that you notice the futures on a security you hold seem under-priced. How can you cash in on this opportunity to earn risk less profits ? Say for instance ABC Ltd., trades at Rs. 1000. One month ABC futures trade at Rs.965 and seem under-priced. As an arbitrageur, you can make risk less profit by entering into the following set of transactions:
On day one, sell the security in the cash/spot market at Rs.1000.
Make delivery of the security.
Simultaneously, buy the futures on the security at Rs.965.
On the futures expiration date, the spot and the futures price converge. Now unwind the position.
Say the security closes at Rs.975. Buy back the security.
The futures position expires with a profit of Rs. 10.
The result is a risk less profit of Rs.25 on the spot position and Rs. 10 on the futures position.
If the returns you get by investing risk less instruments is more than the return from the arbitrage trades, it makes sense for you to arbitrage. This is termed as reverse cash and carry arbitrage. It is this arbitrage activity that ensures that the spot and futures prices stay in line with the cost of carry. As we can see, exploiting arbitrage involves trading on the spot market. As more and more players in the market develop the knowledge and skills to do cash and carry and reverse cash and carry, we will see increased volumes and lower spreads in both the cash as well as the derivatives market.
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