1. Derivative Classroom
Arbitrage- Series VIII
November 18, 2009
Derivative Classroom -Series V `
Arbitrage
An arbitrage is the practice of capitalizing on mis-pricing existing between two
markets. It is a combination of deals that takes advantage of the imbalance
prevailing in cash and future market. In the field of investing, arbitrage can be
bifurcated into two types- Deterministic Arbitrage and Statistical Arbitrage
Implied Volatility Deterministic Arbitrage
In deterministic arbitrage a sure profit can be obtained from being long some
securities and short others
ssss Example:
1. Cash and carry Arbitrage
2. Reverse Cash and Carry Arbitrage
Long on stock, Buy Put
View: Extremely bullish Statistical Arbitrage
Statistical Arbitrage attempts to profit from pricing inefficiencies identified with
mathematical models. Statistical arbitrage attempts to profit from the probability
that prices will move toward a historical average. Unlike Deterministic arbitrage,
statistical arbitrage has risk.
Example:
1. Pair Strategy Arbitrage
Basis I- Cash and Carry Arbitrage
Cash and carry arbitrage entails making profit from the price differential
between cash and futures market, when the basis is positive (Future is quoting
at a premium).
Basis = Futures price- Cash Price
During the month basis can turn in to premium or discount. However as time
decays future price starts converging cash price and eventually expire at the
Spot Price Future Price closing of cash price (VWAP) on expiry.
Profit: (Future price- Cash Price)*Qty
Illustration 1
Suppose Larsen & Turbo November future is quoting at a premium of Rs.25.00.
Mr. Shah is a conservative investor and wants to make a risk less profit. He can
Karun Mutha
execute the following trade. Lot size: 200
Sr. Vice President& Head Derivatives
Tel +91-22-67897833 Initiation Reversal
Email: Karun.mutha@hsbcinv.com Action Scrip Type Yield(%) Days
Price Price
Tina Khetan Buy LT Cash 1600.00 1710.00
Analyst - Derivatives
Tel +91-22-67897828
Email: Tina.khetan@hsbcinv.com Sell LT Futures 1630.00 1710.00 15.27 30.00
Difference 30.00 0.00
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2. Derivative Classroom
Arbitrage- Series VIII
Derivative Classroom -Series V
Long on stock, sell a call option II- Reverse Cash and Carry Arbitrage
View: Neutral/ moderately bullish
Reverse Cash and Carry arbitrage opportunity arises when future is quoting at a
discount to cash price.
Profit = (Cash price of stock – Future price of Stock) * Qty.
Implied Volatility
Profit: (Cash Price of stock- Future Illustration II
Price of stock) * Qty
Suppose Mr. Mehta has 1500 shares of Sesa Goa. Currently Sesa Goa is quoting
ssss at a discount of Rs.10.00. Following trade can be executed
Initiation Reversal
Action Scrip Type Yield(%) Days
Price Price
Buy LT Futures 335.00 290.00
Sell LT Cash 345.00 290.00 24.18 30.00
Difference 10.00 0.00
III-Pair Strategy Arbitrage
As a trading strategy, statistical arbitrage is a quantitative and computational
approach to equity trading. It involves data mining and statistical methods.
Pair trading strategy is one of the statistical arbitrage, in which stocks are put
into pairs based on quantitative simulation or market-based similarities. When
one stock in a pair outperforms the other, the poorer performing stock is bought
long with the expectation that it will climb towards its outperforming partner,
the other is sold short.
Example:
1. Buy Tata Steel- Sell Sail
2. Buy Infosys-Sell Wipro
3. Buy HDFC – Sell Rel Capital
IV-Corporate Action based Arbitrage
Corporate action like Open Offer, Buy back, Mergers and Acquisition too provide
various arbitrage opportunities. In open offer and buy back risk – reward is
determined based on acceptance ratio and we can hedged the likely unaccepted
Buying a lower strike Call and selling shares using futures contract. Profitability varies depending on the purchase
higher strike call price of shares, days for acceptance and acceptance ratio.
View: Bullish
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