Did the Spreads Vanish?

There are typically three types of participants in the market; speculators(traders), hedgers and arbitragers. Arbitrage is though not price impacting is very important to contain price impact. Arbitragers are crucial part of the market as they provide liquidity to the market and remove any mispricing. 

Arbitrage is taking benefit of the difference in pricing of the same asset in two different markets. So, you basically buy in the market where it is cheap and sell the same quantity in the market where it is dearer. For instance, Reliance is quoting at Inr 2100/- in the cash market and September futures are quoting at Inr 2121/-. One can Buy in Cash market and sell the same quantity in Futures market, thus looking the gain of Inr 21/-. That’s almost 1% or 100 bps return, adjusted for cost it comes to nearly 60 bps, annualised at close to 7.5%. These are risk free returns.

So, the next question is what happens to these positions. Either you unwind it or roll it. Unwinding means, on the expiry day or before that you Sell of the Cash position and Buy back the Futures position. On expiry these days because it is stock settled, it can be automatically settled. The problem here is that next expiry you have to again look for such an opportunity. So, the other way out is to roll it, where one holds on to the Cash positon and transfers the Short Position of current expiry to next expiry. This is call Short Rollovers or Short Roll. Now, because the next month future would quote at a higher price than current month, the rollover ends up making gain for the arbitrager. So, if the rollover level is sufficient there is no need to unwind.

Why do futures quote at a premium? A futures contract by its nature is a deferred contract. The execution of it will happen on a future, so as compared to cash it will have an additional interest cost or time value attached to it. This is called the fair value. The time value keeps diminishing as the expiry nears. Another, factor in it is the demand and supply. A stock or index which is more in demand will quote above its fair value. 

So, typically what happens here is, the futures price keep shooting higher and the gap in comparison to the cash price increases significantly, the arbitragers get in to reduce this price mismatch by selling futures and buying cash. The vice versa also holds true. The difference being that in case of reverse arbitrage one needs to have inventory of the stock.

Then why have the spreads shrunk these days? To quickly list a few of them.

• 
  A large part of this arbitrage is done by FIIs, Proprietary traders and Arbitrage Funds managed by Mutual Funds. Currently the Asset Under Management (AUM) of these arbitrage funds managed by MFs is close to 70,000 crores. Add to it the other participants, which indicates around 1,00,000 crores worth of money chasing these opportunities. So, clearly it is becoming too much money chasing too few opportunities. 

• With interest rates coming down the fair value of futures shrink and so the spreads shrink, that’s another reason for this. Arbitrage is more of an interest rate product in that sense. 

• Also, it is a bull market product, one needs Long interest so that people are willing to leverage, that leads to lot of interest in buying futures and eventually spreads opening up. But the market volatility and increased & stringent margin requirements has reduced this interest.

All this put together has led to a shrinking in the spreads and the returns of arbitrage funds coming down to nearly 4% annually this Calendar Year from 6% to 7% in previous years.

Happy Trading!!!

Cheers.