How arbitrage funds leverage market volatility

Arbitrage funds are designed to capitalise on short-term price discrepancies in assets across different markets. Understanding how arbitrage fund use market changes to generate returns can potentially enable investors to decide if such a fund is right for them.

In this article, we'll explore how arbitrage funds can potentially benefit from volatile market conditions.

• Table of contents

1. Understanding market volatility
2. How do arbitrage fund use market volatility?
3. Utilising market volatility in an arbitrage fund
4. Bajaj Finserv Arbitrage Fund

Understanding market volatility

Market volatility refers to rapid and unpredictable fluctuations in an asset’s prices. Periods of high volatility are characterised by sharp swings in prices, both upwards and downwards, creating uncertainty among investors.

How do arbitrage fund use market volatility?

Arbitrage funds which are categorised as hybrid funds operate on the fundamental principle of exploiting price discrepancies across different markets for the same asset. These discrepancies, often brief, arise from temporary inefficiencies in market pricing. The fund manager's expertise lies in identifying and potentially capitalising on these opportunities before they disappear. Some common arbitrage strategies include:

Cash-futures arbitrage: This strategy involves simultaneously buying and selling a security in the cash (spot) market and futures market to exploit price differentials between the two.

Merger arbitrage: Takes advantage of price differentials between the current market price of a target company's stock and the price offered in a merger or acquisition deal.

Convertible arbitrage: Involves buying a convertible security while short-selling the underlying stock to potentially gain from price discrepancies between the two.

Utilising market volatility in an arbitrage fund

Now, let's explore how market volatility plays a crucial role in their strategy:

Amplified discrepancies: Periods of high volatility often exaggerate price discrepancies due to increased uncertainty and emotional reactions from investors. This presents more frequent and potentially larger opportunities for arbitrage funds.

Short-term focus: Arbitrage trades are typically executed quickly, potentially capitalising on momentary misalignments. Volatility, with its rapid price fluctuations, creates more short-term price movements, offering a fertile ground for such swift trades.

Reduced correlation: During volatile periods, asset prices tend to exhibit lower correlation, meaning they move less in tandem. This allows arbitrage funds to diversify their strategies across assets with less overlapping risk, potentially enhancing the returns.

However, it's essential to remember that market volatility can be a double-edged sword. While it presents opportunities, it may also pose challenges such as:

Execution speed: Capitalising on brief discrepancies requires lightning-fast execution, which can be hurt by technical glitches or high trading volumes during volatile periods.

Liquidity risk: Volatile markets can experience reduced liquidity, making it difficult to enter and exit positions quickly, potentially leading to missed opportunities or losses.

Manager skill: Identifying and executing arbitrage trades during high volatility demands exceptional skill and experience from the fund manager. Therefore, due diligence and researching the experience of the fund manager is important when selecting an arbitrage fund.

Bajaj Finserv Arbitrage Fund

Offered by Bajaj Finserv Asset Management Limited, Bajaj Finserv Arbitrage Fund is an open-ended scheme focused on investing in arbitrage opportunities. Its primary investment objective is to generate return potential by capitalising on arbitrage opportunities in the cash and derivatives segments of the equity markets. Additionally, the fund allocates a portion of its assets to debt and money market instruments. It's important to note that there is no guarantee that the fund will achieve its investment objective.

Conclusion

While they don't offer full immunity to risk, arbitrage funds provide a unique approach to navigating volatile markets. Their ability to exploit price discrepancies and potentially benefit from market fluctuations makes them suitable for investors seeking a relatively stable return potential even in turbulent markets. However, it's crucial to understand the inherent risks and ensure the chosen fund boasts a proven track record and skilled management. Remember, diversification remains key, and arbitrage funds should be considered as a component of a well-rounded portfolio, not a standalone investment strategy.

FAQs

How does market volatility affect arbitrage funds?

Market volatility can positively impact arbitrage funds by potentially creating price discrepancies that can be capitalised on. However, it also presents challenges like execution speed, liquidity risk, and increased reliance on manager skill.

What are the different types of arbitrage strategies used by these funds?

Common strategies include merger arbitrage, statistical arbitrage, convertible arbitrage, and fixed-income arbitrage, each exploiting price discrepancies in different market segments.

Can market volatility lead to higher returns for arbitrage funds?

While volatility presents more opportunities, it doesn't guarantee higher returns. Skilled management, efficient execution, and a comprehensive risk management framework are crucial for potentially capitalising on these opportunities.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully.
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