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

Page 1
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

Buying a lower strike Call and selling
higher strike call
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
shares using futures contract. Profitability varies depending on the purchase
price of shares, days for acceptance and acceptance ratio.

View: Bullish

Page 2
Disclaimer:
Issuer of the Document:- HSBC InvestDirect Securities (India) Limited*
Registered Office:-
Dhana Singh Processor Premises
J B Nagar, Andheri - Kurla Road
Andheri (East)
Mumbai – 400 059
Telephone: +91 22 6789 7830
Fax: +91 22 6789 7700
Website: www.hsbcinvestdirect.co.in

Disclosure
HSBC InvestDirect Securities (India) Limited (“HISL”), its associate and group companies, its directors, associates and employees may
have various positions in any of the stocks, securities and financial.
Instruments dealt in this document or may make sale or purchase or other deals in the securities from time to time or may deal in other
securities of the companies / organizations described in this document.

Certification
The views and opinions expressed by the author in the document are his own and do not reflect the views of HSBC InvestDirect
Securities (India) Limited or any of its associate and group companies.

Disclaimer Clause
The above is for customer information only and does not constitute investment advice or an offer to purchase or subscribe for any
investment. This document is not directed to or intended for display, downloading, printing, reproducing or for distribution to or use by
any person or entity who is a citizen or resident or located in any locality, state, country or other jurisdiction where such distribution,
publication, reproduction, availability or use would be contrary to law or regulation or would subject HSBC InvestDirect Securities (India)
Limited (HISL) or its associates or group companies to any registration or licensing requirement within such jurisdiction. If this document
is inadvertently sent or has reached any individual in such country, the same may be ignored and brought to the attention of the sender.
This document may not be reproduced, distributed or published for any purpose without prior written approval of HISL.

This document is not intended to provide legal, accounting or tax advice and should not be relied upon in that regard. Persons accessing
this document are advised to obtain appropriate legal, accounting or tax advice where necessary. Financial advice provided has not been
prepared taking into account the particular investment objectives, financial situation and needs of any particular investor. As a result,
investors using the advice should assess whether it is appropriate in the light of their own individual circumstances before acting on it.

* Formerly known as IL&FS Investsmart Securities Limited