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The Participants In The Derivatives Market: Arbitrageurs

By Expert Author: Artham Vidya

Arbitrageurs, as we know, take advantage of price differentials across different markets and use that to make profits. For instance, they identify differences in the price of futures and the underlying spot prices and trade on that difference.

We will show with an example how an arbitrage trade takes place with index futures and the spot values.

Scenario: Assume that the spot Nifty is trading at 1280.
June futures closed today at 1300
There are still 28 days to expiry of June futures

If we assume the riskless market return at 11.50% per annum (for the sake of argument) then the risk-free rate of return for 28 days is 0.88%. (11.50/365 x 28)

Now we calculate the implied futures interest rate:

1300-1280/1280 x 100 = 1.56%

This means that the futures are trading at a premium to the spot value.

Strategy: Here is what the arbitrageur does to take advantage of the mispricing in the two segments and get return of 0.68 percent (the difference between the implied futures interest rate and the risk-free market return)

He borrows Rs 2, 56,000 (1280 x 200) over the period to expiry at 0.88 percent market rate of return. In a simultaneous transaction, he lends forward at 1.56 percent by selling one June contract at 1300.

On the day of expiry, the following market actions are observed:

The spot index closes at 1290
The June futures are at 1290

The arbitrageur makes a gain of Rs 2000 on his futures position

(1300-1290) x 200 = 2000

The spot index value is 1290 x 200 = Rs 2, 58,000
Interest payment at 0.88% = 2253

The spot index payment = 2, 56,000 + Interest Payment
= 2, 58,253

The loss from the spot index transaction = spot index value – spot index payout
= 2, 58,000 – 2, 58,253
= 253

So the arbitrageur makes an absolute return of 2000 – 253 = 1747, which is 0.68 percent of his cash index investment.

When making an arbitrage trade you have to realise that it is not free or risk-free. The costs you have to bear are transaction costs, brokerage costs, bid-ask spreads and of the course, the impact cost.

You have to be very sure of the pricing in the markets before you attempt an arbitrage trade.

Forward contracts, we have explained in our previous segment, are used to reduce the risk from adverse price movements in financial assets and commodities.

When you lock-in the prices, you are protecting yourself from losses arising from price volatilities in prices of assets.

The most common derivatives contracts (which are traded on the exchanges) are futures, options and swaps. We will deal with futures and options first.

Derivatives are mainly used by three categories of participants in the financial (including currency) and commodities markets. They are hedgers, speculators and arbitrageurs.

Hedgers, as stated earlier, seek to eliminate risk associated with the swing in the prices of an asset.

Speculators try to anticipate the swing in prices of assets in the future and take positions accordingly in the derivatives market.

Arbitrageurs take advantage of the price differentials in the derivatives and futures segment and take offsetting positions in the two segments to make profits.

All three types of participants are responsible for the liquidity of the derivatives segment, pricing and the direction in which futures and options move.

Futures: These are standardised forward contracts. So if you want to reduce the risk in your portfolio of assets – stocks, commodities, precious metals – then instead of searching around for another party to enter into a contract, you just need to buy the ready-made, required futures contract through an exchange.

The following items are standardised in a futures contract:
•The quantity of the underlying asset.
•The quality of the underlying asset.
•The date on which the delivery of underlying asset takes place.
•The pricing of the contract and the minimum price change.

Options: In an options contract, the buyer (of the option) gets the right but not the obligation to buy or sell an asset at a predetermined price at or before a future specified date.

The option holder may decide to exercise the option of buying or selling only if the price moves favourably for him. So though he has the right, he may chose not to do it, so he is not obliged to exercise the option.

The main difference between a futures and options contract lies in the obligation of the purchaser. In a futures contract both parties are obliged to stick to the terms of the contract.

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