Arbitrage fund
A mutual fund that buys in the cash market and simultaneously sells in the futures market to lock in the price difference, giving low NAV volatility similar to a liquid fund.
In plain language
The same share can trade at one price in the cash (spot) market and at a slightly different price in the futures market. An arbitrage fund earns its return from that gap, not from the direction of the market.
It buys the share in the cash market and sells it in the futures market at the same time. On the expiry of the futures contract both positions close at the same price, so whatever the share has done in between, the fund keeps the difference it locked in on day one.
That is why the workbook calls a completely hedged position a low-risk investment proposition, with NAV volatility similar to that of a liquid fund.
How it works
The mechanism. Buy in the spot market, sell in the derivatives market, hold until the expiry of the derivative cycle. On the settlement date both positions are closed at the same price and the difference is realised.
Why a mutual fund can do it cleanly. For a trader, the price gap is only profitable if it exceeds the cost of borrowing the money to buy the shares. The workbook points out that in the case of mutual funds there is no cost of borrowing.
Where it sits in the fund categories. The workbook lists arbitrage funds among the hybrid schemes, following an arbitrage strategy with a minimum of 65 percent in equity and related instruments. It sits alongside:
| Category | Allocation rule |
|---|---|
| Conservative hybrid | 75–90% debt, 10–25% equity |
| Balanced hybrid | 40–60% equity, 40–60% debt |
| Aggressive hybrid | 65–80% equity, 20–35% debt |
| Multi-asset allocation | At least 3 asset classes, minimum 10% each |
| Arbitrage | Minimum 65% in equity and related instruments |
| Equity savings | Minimum 65% equity, minimum 10% debt |
The 65 percent equity figure and the liquid-fund-like volatility are not a contradiction: the equity is held fully hedged, so the market risk of the shares is offset by the futures position.
A worked example
The workbook's illustration. A fund buys shares in the cash market at Rs 80 and sells in the futures market at Rs 100 — a gain of Rs 20 locked in.
Scaled up, to show why the direction of the market does not matter (illustrative quantity). The fund buys 1,000 shares at Rs 80 and sells futures on 1,000 shares at Rs 100.
| At expiry the share is | Cash leg | Futures leg | Net |
|---|---|---|---|
| Rs 90 | 1,000 × (90 − 80) = + Rs 10,000 | 1,000 × (100 − 90) = + Rs 10,000 | + Rs 20,000 |
| Rs 110 | 1,000 × (110 − 80) = + Rs 30,000 | 1,000 × (100 − 110) = − Rs 10,000 | + Rs 20,000 |
| Rs 70 | 1,000 × (70 − 80) = − Rs 10,000 | 1,000 × (100 − 70) = + Rs 30,000 | + Rs 20,000 |
The share price at expiry changes which leg makes the money, never the total. The fund's Rs 20,000 was fixed the moment both trades were placed.
(The workbook's Rs 20 on Rs 80 is a teaching figure chosen to make the arithmetic visible, not a typical spread.)
Why NISM asks about it
Chapter 2, section 2.10.9 (Mutual Funds), describes arbitrage funds twice: once among the hybrid categories with the 65 percent equity minimum, and once with the spot-futures mechanism and the Rs 80 / Rs 100 illustration. Expect a question on the source of return (the price differential, not market direction), the comparison of volatility with a liquid fund, and the 65 percent figure in a category-matching question.
Common exam traps
- The return does not depend on the market going up. It depends on the spot-futures gap and on holding both legs to expiry.
- Buy spot, sell futures — not the other way round.
- 65 percent equity does not make it a high-risk fund. The equity is hedged; the workbook compares its NAV volatility with a liquid fund.
- No cost of borrowing for a mutual fund. That is what makes the locked-in differential the fund's return; for a leveraged trader the differential must exceed the borrowing cost.
- Arbitrage fund versus equity savings fund. Both carry a 65 percent equity minimum in the workbook's list; the equity savings fund adds a minimum 10 percent in debt.
- The workbook's wording is loose. It says the fund earns "the interest rate differential" and, in the same passage, "the price differential". The mechanism described is the price differential between spot and futures.
Where this is taught
- Series X-A · Chapter 11: Mutual Fundintroduced here
- Series XVII · Chapter 2: Financial Markets & Investment Productsintroduced here
Related terms
- Mutual fundA trust registered with SEBI that pools money from many investors and invests it in securities on their behalf — not a different product from shares and bonds, but a different way of owning them.
- ArbitrageSimultaneously buying and selling an asset, or a replica of it, in different markets to profit from a price discrepancy — a trade that aims to lock in a profit rather than bet on direction.
- Liquid fundAn open-ended debt scheme investing only in debt and money market securities maturing within 91 days — among the lowest-risk mutual funds, used to park short-term surplus money.
- Balanced Hybrid FundAn open-ended hybrid scheme with 40% to 60% in equity and 40% to 60% in debt, and no arbitrage allowed. It sits below the aggressive hybrid fund on the workbook's risk ladder.
- Cash and carry arbitrageBuying the underlying in the cash market and simultaneously selling futures when futures trade above their fair price, carrying the asset to expiry to lock in the mispricing.