Reverse arbitrage
Also written Reverse arbitrage (single bond IRF) · Reverse cash and carry arbitrage
Selling a bond, lending in repo and buying futures on the same bond when futures trade below theoretical value — a locked-in pay-off not open to all, as short selling G-Secs is restricted.
In plain language
Reverse arbitrage is the trade for a bond future that is too cheap.
The workbook describes it as: sell the GOI bond in the underlying market, lend money in the repo market against the same GOI bond, and buy futures of the same GOI bond. It is generally possible when the futures price is lower than the theoretical futures price.
The arbitrager gives up the bond now, earns interest on the cash, and buys the bond back forward at a fixed, low price. As with regular arbitrage, price moves in the bond cancel between the two legs, and what is left is a locked-in pay-off.
The catch is in the first step. Selling a bond you do not already own is short selling, and in India short selling of GOI securities is not allowed to all participants. The workbook adds that an arbitrager who already holds the bond can sell it and lend the money till expiry in any risk-free instrument.
How it works
The positions.
| Leg | Position | Earns | Costs |
|---|---|---|---|
| Underlying GOI bond | Sold | Price gain if bond falls | Price loss if bond rises; accrued interest given up |
| Repo | Money lent against the same bond | Lending income | — |
| Bond futures | Bought | Gain if bond rises | Loss if bond falls |
Compared with regular arbitrage, every sign flips: accrued interest becomes an outflow (the arbitrager no longer earns it), and repo interest becomes income instead of a borrowing cost.
Why access is limited.
- Short selling is allowed only in certain securities and for certain entities.
- RBI allows short sale up to 90 days, and the short seller must borrow the security to make delivery.
- The workbook names this directly as a regulatory limit on the reverse arbitrage example: short sell of bonds in the underlying market may not be allowed to all participants.
The same execution risks apply: a gap between orders, an illiquid leg leaving naked exposure, unwinding risk, and frictions — brokerage, stamp duty, margin cost and impact cost — that the example ignores.
A worked example
The workbook's example. On 3 August, 7.59% GOI trades at Rs 102.60 and the August futures at Rs 102.40 — below where cash and carry says they should be. Face value Rs 10 crore, 500 lots. Repo lending rate 5%.
Trade: sell Rs 10 crore of the bond at 102.60; lend the proceeds in repo; buy 500 lots of futures at 102.40.
At August expiry:
| Case I — bond at 102.30 | Case II — bond at 102.80 | |
|---|---|---|
| Income from lending | 2,95,151 | 2,95,151 |
| Underlying bond (sold at 102.60) | +3,00,000 | −2,00,000 |
| Futures (bought at 102.40) | −1,00,000 | +4,00,000 |
| Accrued interest forgone | −4,42,750 | −4,42,750 |
| Net pay-off | Rs 52,401 | Rs 52,401 |
Check Case II: futures (102.80 − 102.40) × 10,00,000 = Rs 4,00,000; bond (102.80 − 102.60) × 10,00,000 = Rs 2,00,000 loss.
Case I: (2,95,151 + 3,00,000) − (4,42,750 + 1,00,000) = 5,95,151 − 5,42,750 = 52,401
Case II: (2,95,151 + 4,00,000) − (4,42,750 + 2,00,000) = 6,95,151 − 6,42,750 = 52,401
Identical again. Notice what the arbitrager pays for the privilege: Rs 4,42,750 of accrued interest he would have earned by holding the bond. The trade still works because the futures were 20 paise below the cash price, and that gap on Rs 10 crore more than covers the difference between the bond's coupon and the repo rate.
Why NISM asks about it
Chapter 5 (Strategies using Interest Rate Derivatives), section 5.5.2, works reverse arbitrage with the same 7.59% GOI bond as the regular arbitrage example, then notes that short selling in the underlying may not be allowed to all participants. Chapter 1 explains the short sale rules and why short sellers borrow securities. Expect a question on the three legs, on when the strategy is possible, and on the regulatory constraint.
Common exam traps
- Reverse arbitrage = sell bond + lend in repo + buy futures. Three legs, not two.
- Possible when futures trade below the theoretical price.
- Accrued interest is an outflow here — the arbitrager has given the bond up.
- Repo lending is income, not a cost.
- Not open to everyone, because short selling GOI securities is restricted to certain securities and entities.
- An existing holder can do it without a short sale, lending the proceeds in any risk-free instrument till expiry.
- Same pay-off in both price cases — Rs 52,401 in the workbook — before frictions.
Check yourself
1.Why does the workbook say interest rate derivatives are a good choice for a trader who wants to take a bearish view on GOI bond prices?
- a)Because in India not all participants are allowed to short sell Government of India securities; the trader can sell GOI bond futures or buy GOI bond put options instead
- b)Because bond futures are exempt from margin for short positions
- c)Because a short position in bond futures earns accrued interest
- d)Because the only way to profit from falling bond prices is by writing call options
Show the answer
Answer: (a) Because in India not all participants are allowed to short sell Government of India securities; the trader can sell GOI bond futures or buy GOI bond put options instead
"In India, not all participants are allowed to do short sell in government of India securities. Hence, Interest rate derivatives will be the good choice to take such view. The trader can either sell GOI bond futures or he can buy the GOI bond put option contracts to take the short position in bond."
The same restriction appears as a practical limit on reverse arbitrage: "short sell of bonds in underlying market may not be allowed to all participants."
- (b) is not stated — futures positions carry margins.
- (c) is wrong: accrued interest belongs to the holder of the bond, and futures positions earn none.
- (d) is wrong: the workbook names selling futures and buying puts as the ways to go short.
Where this is taught
Free preparation for NISM Series IVRelated terms
- RepoA ready forward contract: borrowing money by selling securities with an agreement to buy them back later at a higher price that includes the interest.
- ArbitragerA participant who locks a profit by entering opposite transactions in two markets at once — carrying no exposure and taking no view, and in the process pulling the two prices back together.
- Cash and carry pricingThe no-arbitrage model for bond futures: theoretical futures price = cash (dirty) price + financing cost − income on the cash position, which is accrued interest to the futures settlement date.
- Government Securities LendingLending a specific government security for a fee against the collateral of other government securities for a fixed period, under RBI's GSL Directions, 2023 — both securities are returned at the end.
- Interest Rate FuturesA standardised exchange-traded contract to buy or sell a notional government security, or an interest rate itself, at a price agreed today for settlement on a future date.
- Regular arbitrageBuying a bond in the underlying market and selling futures on the same bond when futures trade above their theoretical price — locking in a pay-off that is the same whether the bond price rises or falls.
- Naked positionA long or short position in a futures contract held without any position in the underlying asset or an offsetting contract — fully exposed to price moves in one direction.
- Execution riskThe risk that a trade does not execute as planned — that prices move between the legs of a strategy, that one leg fails to fill, or that an order fills away from the desired price.