VEDANT FINALPROJECT

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VEDANT UPADHYAYA 4105214214

1.1 ABOUT THE PROJECT

In this project I have studied about the possible opportunities of arbitrage

available between MCX and NCDEX in the commodity gold.

There exist price differences between the same commodity in twodifferent exchanges. This difference gives rise to arbitraging opportunities in

the commodity.

An arbitrager buys from the exchange where the price is less and sells in

the exchange where the price is more. But he should also consider the cost of

transaction. If the cost of transaction is more than the spread then arbitrage

opportunity is not available. Only if the cost of transaction is less than that of

spread arbitrage is possible.

I have calculated the NET SPREAD keeping in mind the cost of transaction

and found out whether arbitrage opportunities exist or not.

Analysis of Arbitrage opportunities in Gold between MCX and NCDEXee

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1.2 WHY COMMODITY GOLD WAS CHOSEN

Gold is the indicator of an economy. A countrys economy is rated by the

gold reserves it has. The supply of money in the economy of India is backed

up by gold.

Moreover gold is considered as the best hedge against inflation. In an

economy where the inflation is rising and the value of money is falling, one

should invest in gold. The value of gold rises with the rise in inflation and

hence provide for hedging against inflation.

The prices of gold depend on a large number of factors and hence it is an

important commodity. The prices rise during the marriage and festivalseason due to heavy demand and they fall after the season is over.

Gold is valued in India as a savings and investment vehicle and is the second

preferred investment after bank deposits. The gold hoarding tendency is well

ingrained in Indian society


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1.3 COMPANY PROFILE

Jaypee Commodities PVT LTD.

Our Mission

At Jaypee, our mission is to provide the investors, traders with

trading opportunities in multiple markets across the globe and proprietary

research and knowledge for effective decision making.

It is our commitment to partner with each of our clients, offer

them personalized service with 24-hour execution using the latest technology

and help in achieving their financial goals using various exchange traded

financial products like stocks, options, futures, ETFs, commodities, foreign

currency on all major securities and futures exchange worldwide. We service

a global network of brokers, investors (new or experienced), and high

volume traders, financial, industrial and agricultural institutions.

Our Beliefs

KnowledgeAwareness Opportunities

We believe that by keeping our clients aware about the markets

and providing them with value added trade information and financial

knowledge we would be able to help them in identifying and takingadvantage of opportunities and achieve their financial return objectives. We

strive to realize the value of a split second for our valued clients, which

furnish exceptional trading opportunities


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Our Dedication

Market are always right.and we respect that

We are dedicated to provide our clients with the latest in

financial trading tools available and adapt ourselves and offer new trading

strategies and opportunities enabling our clients to be successful investors

and traders. We are dedicated to work with you in bull and bear markets,

market ups and downs. We are committed to our people, our clients and our

beliefs.

Unlike a huge conglomerate where a client is only a number at

Jaypee our clients receive personal attention. Our people are dedicated to

providing its clients with best financial brokerage services.

Our Services

The investment philosophy of Jaypee focuses on recommending

buy in companies/sectors that have a growth potential and are technically

strong and recommending to sell in companies/sectors that have lost the

steam or are technically weak. We advise our clients on a daily basis on how

to maximize their returns on the stocks bought/sold by suggesting exit/stop-

loss or re-entry points in the respective stocks/positions of its clients while

keeping in mind their investment objectives, personal financial situation,

time horizon and risk taking ability.

At Jaypee , teams of skilled financial professionals constantly

monitor a whole gamut of investment opportunities in companies so as to

recommend buy/sell on the basis of their analysis and research. The

companies are selected on the basis of various quantitative and qualitative


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factors. Order Execution is our main strength; our endeavor is to get the

"deals done" as soon as you place them. We want our clients to take

advantage of each and every tick movement.

Markets are Always Right! And we respect that

We also believe that the difference between a great investor and

a poor investor is not essentially that the poor investor makes more mistakes

but the difference in their ability to maximize the return from winning trades

and minimize the losses from the mistakes. Through our market research and

analysis we ensure that we are in line with the market, both on the bull and

the bear side, enabling us to maximize returns from winning trades and

minimizing from the mistakes.

Jaypee has the following service areas: -

We provide real-time quotes to our clients ensuring that they do

not miss the bus and have access to reliable data quickly.

Capital Markets Segment

Our firm's operations started in this segment. We have a rich

experience of dealing in this segment.

Derivatives Segment

Our continuous efforts to understand this segment have enabled

us to provide innovative strategies to our clients from which they can

benefit.

Equity Research

We synergize our experience in the trade with expertise of our

research analysts to provide our clients with adequate information.

Client Relations


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We believe in keeping our clients satisfied all the time. We are

known to provide prompt service to our clients. We ensure that clients get a

personalized service that enables them to meet their investment objectives.

Call us for up to date facts and figures on all the stocks before you make

your investment decision. One of our experienced executives will be pleased

to give you an advisory service when you require it.

We offer two types of Broking/Dealing Services: -

Dealing Service

It is our standard level of service where clients can telephone or

Email their orders to us. A trader will confirm the order. The clients can

check back at any time to confirm whether the trade has been executed or

not. A confirmation of the trades will be sent at the end of the trading

session. Payments / deliveries etc. should be sent or picked up by clients.

Advisory Service

A personal trader assigned to you will be responsible for all

your orders and for confirming trades executed. The trader will update you

on any significant movements in the market and your shares. You will be

given our advice on a daily basis to maximize your returns either by buying

or selling or holding the scrips, if you desire. Confirmations may be faxed,

emailed or given on the telephone. We will collect deliveries, cheques and

all other documents for our local clients.

The Jaypee Advantage


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Professional Support

Every Tick Counts !

We are there with you at every step. If you have any questions please feel

free to call or email us.

Direct Access

We provide our clients with 24/7direct access trading and order routing

platform systems and online account view.

Global Presence

We can assist Traders, Institutions and Individual Clients to trade

global equity and commodities markets and Asian exchanges in India and

Dubai.

Multiple Markets

A basket of financial instruments to choose from!

Equities, Options, Commodities, Futures, Metals & Energy etc.


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2.1 INTRODUCTION TO COMMODITY MARKET

Over the modern age of investing, commodity trading has emerged as an

important player in the way that people invest in and speculate. It was

developed as a reaction to the way that business is conducted, and it

continues today in the form of commodities trading online. Many different


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people turn their business know how into a profitable venture, and it is

commodities and futures trading that helps them get there. It might sound

like a strange term, but simply put, commodities are items like, wheat, corn,

gold and silver, and Cattle and Pork Bellies, and Crude Oil. When farmers

take their crop to "market", they are selling commodities. Trading

commodities is the world's one perfect business. The upside potential is

unlimited and you can control the downside. You can trade commodities on

a part time basis or a full-time basis. You can spend as little as an hour or

two a day yet earn a full-time income.I've met people who have started with

a small account and in a short period of time, six months to a year, built their

account up to the point that they have been able to quit their jobs and trade

commodities full-time providing themselves with a very comfortable

lifestyle. Commodities are fascinating. Most people who become traders,

even with a very small account, really never quit following the markets.

Most of the people who trade commodities are just average hard working

people, probably a lot like you who are just trying to supplement their

income and trade on a part time basis.

CommodityBasics:

Commodities are raw materials used to create the products consumers buy, from food to

furniture to gasoline. Commodities include agricultural products such as wheat and

cattle, energy products such as oil and gasoline, and metals such as gold, silver and

aluminum. There are also soft commodities, or those that cannot be stored for long


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periods of time. Soft commodities are sugar, cotton, cocoa and coffee.The commodity

market has evolved significantly from the days when farmers hauled bushels of wheat

and corn to the local market. In the 1800s, demand for standardized contracts for

trading agricultural products led to the development of commodity futures exchanges.

Today, futures and options contracts on a huge array of agricultural products, metals,

energy products and soft commodities can be traded on exchanges all over the

world.Commodities have also evolved as an asset class with the development of

commodity futures indexes and, more recently, the introduction of investment vehicles

that track commodity indexes.

Investor interest in commodities has increased dramatically in recent years as the asset

class has outperformed traditional assets such as stocks and bonds. The performance of

commodities as an asset class is usually measured by the returns on a commodity index,

such as the Dow Jones-AIG Commodity Index, which tracks the return from a passive

investment in 19 different commodity futures contracts. Over a five year period ended

March 31, 2006, the Dow Jones AIG Commodity Index has returned 10.6%, versus

2.6% for the S&P 500. Commodity prices have been driven higher by a number of

factors, including increased demand from China, India and other emerging countries

that need oil, steel and other commodities to support manufacturing and infrastructure

development. The commodity supply chain has also suffered from a lack of investment,

creating bottlenecks and adding an insurance premium and/or a convenience yield to the

returns of many commodity futures. Over the long term, these economic factors are

likely to support continued gains in commodity index returns.The potential for attractive

returns is probably the most obvious reason for increased investor interest in

commodities, but it isn't the only factor. Commodities may offer investors other

significant benefits, including enhanced portfolio diversification and a hedge against

inflation and event risk.Commodities are real assets, unlike stocks and bonds, which are


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financial assets. Commodities, therefore, tend to react to changing economic

fundamentals in different ways than traditional financial assets. For example,

commodities are one of the few asset classes that tend to benefit from rising inflation.

As demand for goods and services increases, the price of those goods and services

usually goes up as well, as do the prices of the commodities used to produce those

goods and services. Because commodity prices usually rise when inflation is

accelerating, investing in commodities may provide portfolios with a hedge against

inflation.Leverage is very important to the commodities markets. Unlike the stock

market, where you might have to invest 10,000 dollars to leverage 10,000 dollars. A

commodities trader can leverage tens of thousands of dollars worth of a commodity for

pennies on the dollar. Also unlike stocks, commodities have intrinsic value and will not

go bankrupt.The futures markets are so crucial to the well being of our nation, that the

government established the Commodity Futures Trading Commission (CFTC) to

oversee the industry. There is also a self-regulatory body, the National Futures

Association (NFA), who monitor the activities of all futures market professionals to

ensure the integrity of the futures markets.Commodities also give the investor the

ability to participate in virtually all sectors of the world economy and have the potential

to produce returns that tend to be independent of other markets. In fact portfolios that

add commodity investments can actually lower the overall portfolio risk by

diversification.

Just about every product that you consume would likely cost dramaticallymore without the commodities futures markets. Because of the intrinsic risks

associated to being in business, lacking the ability to shift risk, a

manufacturer/producer of goods or services would be forced to charge

higher prices, and the consumer would have to pay those higher prices. This


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shifting of risk to someone willing to accept it is called hedging.

Manufacturers could effectively lock in a sales price by going short an

equivalent amount of goods with futures contracts. If a mining company

knew that they were going to sell 1000 ounces of gold in several months,

they could protect themselves for a future price decline by going short 10

gold futures contracts today. If the price of gold fell by $30 in the following

months, they would receive that much less in the cash marketplace for their

gold, but earn that much back when they offset their short gold futures

position. The futures price will eventually become the cash price. A user or

buyer of goods can use the futures market in the same manner. They would

need to protect themselves from a future price increase, and therefore go

long futures contracts.The person willingly accepting a risk does so because

of the opportunity to profit from price movements, this is known as

speculating. The cotton in your shirt, the orange juice, cereal and coffee you

had for breakfast, the lumber, copper and mortgage for your home, the gas or

ethanol that you put in your car all would be priced many times higher

without the participation of speculators in the futures markets. Through

supply and demand market forces, equilibrium prices are reached in an

orderly and equitable manner within the exchanges, and world economies,

and you, benefit tremendously from futures trading.

Many new commodity traders mistakenly believe that commission rates will

have a greater impact on their trading success than the markets themselves.

Reasonable full service rates are not usually the cause for losses. Bad trades

are the cause for most losses. Many new traders begin trading commodities

with a discount account and rationalize that their trading accounts are

discount so why not do the same for their commodity account.The most

important question to ask is, Will a discount broker monitor your account to


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make sure you dont make a costly mistake? Other questions to ask are:

"Will they let you know that your sell order you are trying to place will

initiate another short future because you meant to offset a short with a buy

not a sell to exit your trade? Will they alert you to the fact that there is a

major USDA grain report coming out before you place your grain order?

Will they call you and let you know that your options have just 1 week

before they expire?" All of the examples above can be very costly to the new

trader. The answers to all of the questions above is no, because discount

brokers are not paid enough to do so.

What qualities do you want your commodity broker to have?

1. Experience- Always make sure that your commodity broker has

seen both bull and bear commodity markets. Also make sure that your

commodity broker does not have a habit of being in trouble with the

National Futures Association.

2. Honest dialogue- Does your commodity broker call you when

you are down in a trade as readily as when you are in a winner? Does

your broker only call to ask you to send in more risk capital?

3. Availability during market hours- Is your commodity broker

very often in a meeting or on the other line when you are trying to

reach them during the trading day? Are your calls returned in a prompt

and

professional manner?

There are many variables to consider when opening an account with a new

commodity broker.


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First you should fully research and understand the inherent risks involved in

commodity investments and decide how much risk capital is appropriate for

your financial situation. Second, you must decide what type of commodity

broker services you will need to achieve your trading objectives. Then you

must decide what type of account will be appropriate for you.

There are several types of services and accounts to choose from:

Full service account. A full service account is where a professional

commodity broker suggests trades for your account, monitors your account,

services your account and lets you know if its time to cut losses or lock

in profits on a particular trade. These are non discretionary which means that

the commodity broker will not buy or sell at their own discretion or without

your approval. Because of the additional time and effort involved

in these accounts commissions are usually highest for full service accounts.

Check the commission schedule before trading. This type of account is for

investors that want to participate in commodities but lack the time and

inclination to trade based on their own research and opinions.

Broker assisted account. This type of account is for an investor that knows

what they want to trade but want to call it into a commodity broker to place

the trade just so there are no order mistakes and to have brief dialogue with a

commodity broker. Order errors can be costly. This type of service also

allows for brief conversations with your commodity broker. This account is

the happy median between using a full service commodity broker or a

discount commodity broker.


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what was going on in the war, and was also affected by the likelihood that

Saddam Hussein would be able to retain control of Iraq. For other

commodities such as crops, weather plays an extremely significant

role in price changes. If the weather in a certain region is going to affect the

supply of a commodity, the price of that commodity will be affected irectly.

As with other securities, many traders use commodity futures to speculate on

future price movements. These investors analyze various events in the

market to speculate on future supply and demand. They subsequently

enter long or short futures positions depending on which direction they

believe supply and demand will move.

Most traders when asked, say that they generally use Daily Commodity price

charts. Maybe out of habit, or because most end up trading at that time level

that this has become popular. Because most traders focus on the Daily or

Intraday Commodity charts by a much larger margin than the Weekly or

higher time frames, you can see this in the more erratic pattern formations

found in these lower time frame charts as traders place their buy and sell

orders to make market. The Weekly chart is a much more concentrated look

of mass psychology as opposed to the Daily chart. For the sake of example

only, say each day brings 100,000 traders to the market and each only makes

one trading act per day. That would mean that each price Daily price bar

represents the mass psychology of 100,000 minds making 100,000 market

actions. In contrast, a single Weekly price bar then would represent 500,000

minds making 500,000 market actions. Now, if you consider that 1 inch of a

price chart may hold about 10 price bars, that 1 inch of market patterns is

representing 1,000,000 minds and market actions for the Daily price pattern,

but 5,000,000 for the same amount of space on the Weekly chart. When you


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consider the word 'Mass', which has more of it? The Weekly chart of course!

If you find yourself spending more time using the Daily charts to analyze the

commodity markets for trading, and you are not daytrading, it is advisable

that you consider seeing the bigger and more accurate picture of market

direction by using the Weekly commodity chart.

Capturing the full benefits of commodity exposure has been a challenge in

the past. Investing in physical commodities such as a barrel of oil, a herd of

cattle or a bushel of wheat is of course, quite impractical, so investors have

tended to look for commodity exposure either by purchasing commodity

related equities or through actively managed futures accounts.

The onset of investment vehicles that track commodity futures indices has

provided investors with another option for gaining exposure to commodities

that may offer better potential to capture the full benefits of the asset class.

Investment vehicles that track commodity futures indices are not the same as

actively managed futures accounts. Instead, commodity index returns

provide passive exposure to a broad range of commodities. For example, the

Dow Jones AIG Commodity Index tracks the futures price of 19 different

commodities, including energy, livestock, grains, industrial metals, precious

metals and soft commodities. Changes to the composition of the index are

determined by preset rules rather than a managers discretion.One advantage

of commodity exposure that tracks a broad index is that commodities are not

highly correlated with each other and index returns should be less volatile

than the returns on an individual commodity. Another advantage is that

commodity indexes themselves have existed for decades, providing ample

historic data for asset allocation studies and research.


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Commodities markets have gained wide popularity among investors because

of their enormous size and transparencies turn over of commodities market is

many times to that of the securities of securities essential because the

commodities traded in commoditymarket are essential and are of daily use

Also it is not false in case of Indian financial market. Commodity trading

and commodity markets are not new to India and its all hundred years old in

India. Earlier years we have used forward contract trading at regional level

in the commodity market. Introduction of innovative derivative products like

Futures and Option in this market gives newer face to commodity market.

In Indian commodity market a future trading was introduced from year 2003

by starting of national level Commodity exchanges. A future trading is

defined as a futures contract is an agreement between two parties to buy or

sell an asset at a certain time in the future at a certain price. Futures contracts

are special types of forward contracts in the sense that the former arestandardized exchange-traded contracts. The following three broad

categories of participants - Hedgers are interested in transferring risk

associated with transacting or carrying underlying physical asset. They use

commodity futures to reduce or limit the price risk of transacting underlying

physical asset. Speculators are interested in making money by taking view

on future price movements. Commodity futures allow speculators to create

high leveraged position to undertake calculative risk with the objective of

correctly predicting the market movement.s Arbitrager are interested in

locking in a minimum risk less profit by simultaneously entering into

transactions in two or more markets. Arbitragers lock in profit when they


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spot cash and carry arbitrage opportunity or reverse cash and carry arbitrage

opportunity.

In this project report I mainly concentrated towards the Arbitragers. Initially

by studying the commodities trading in the Indian commodity futures market

or exchanges especially agri commodity. For the arbitragers arbitrage

opportunity may exist in different way like mis-pricing in the spot and future

exchange, inter exchanges (Between the two exchanges).

Conclusion

Commodities are a distinct asset class with returns that are for the most part

independent of stock and bond returns. Therefore, investing in commodities

can help diversify a portfolio of stocks and bonds, lowering risk and possibly

boosting returns. Reaching this level of diversification has been made easier

with the development of investment products that passively track a broad

range of commodities.

2.2 INTRODUCTION TO DERIVATIVE MARKET

Introduction to Derivatives


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The emergence of the market for derivative products, most notably forwards,

futures and options, can be traced back to the willingness of risk-averse

economic agents to guard themselves against uncertainties arising out of

fluctuations in asset prices. By their very nature, the financial markets are

marked by a very high degree of volatility. Through the use of derivative

products, it is possible to partially or fully transfer price risks by lockingin

asset prices. As instruments of risk management, these generally do not

influence the fluctuations in the underlying asset prices. However, by

locking-in asset prices, derivative products minimize the impact of

fluctuations in asset prices on the profitability and cash flow situation of

risk-averse investors.

Definition of Derivatives

Derivative is a product whose value is derived from the value of one or more

basic variables, called bases (underlying asset, index, or reference rate), in a

contractual manner. The underlying asset can be equity, Forex, commodity

or any other asset.

For example, wheat farmers may wish to sell their harvest at a future date to

eliminate the risk of a change in prices by that date. Such a transaction is an

example of a derivative. The price of this derivative is driven by the spot

price of wheat which is the underlying.

In the Indian context of the Securities Contracts (Regulation) Act, 1956

(SC(R) A) defines derivative to include


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1. A security derived from a debt instrument, share, loan whether

secured or unsecured, risk instrument or contract for differences or any other

form of security.

2. A contract which derives its value from the prices, or index of

prices, of underlying securities.

Derivatives are securities under the SC(R) A and hence the trading of

derivatives is governed by the regulatory framework under the SC(R) A.

Derivatives Markets

Derivatives have probably been around for as long as people have been

trading with one another. Forward contracting dates back at least to the 12th

century, and well have been around before then. Merchants entered into

contracts with one another for future delivery of specified amount of

commodities at specified price. A primary motivation for pre-arranging a

buyer or seller for a stock of commodities in early forward contracts was to

lessen the possibility that large swings would inhibit marketing the

commodity after a harvest.

Types Derivatives Market

Derivative markets can broadly be classified as commodity derivative

market and financial derivatives markets. As the name suggest, commodity

derivatives markets trade contracts for which the underlying asset is a

commodity. It can be an agricultural commodity like wheat, soybeans,

rapeseed, cotton, etc or precious metals like gold, silver, etc.


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Financial derivatives markets trade contracts that have a financial asset or

variable as the underlying. The most popular financial derivatives are those,

which have equity, interest rates and exchange rates as the underlying.

Financial derivatives are used to hedge the exposure to market risk.

The commodity derivatives differ from the financial derivatives mainly in

the following two aspects

Firstly, due to the bulky nature of the underlying assets, physical

settlement in commodity derivatives creates the need for warehousing.

Secondly, in the case of commodities, the quality of the asset

underlying a contract can vary largely.

Products, Participants and Functions

Products

Derivative contracts have several variants. The most common variants are

Forwards

Futures

Options

Swaps

Forwards


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A forward contract is a customized contract between two entities, where

settlement takes place on a specific date in the future at todays pre-agreed

price.

Futures

A futures contract is an agreement between two parties to buy or sell an asset

at a certain time in the future at a certain price. Futures contracts are special

types of forward contracts in the sense that the former are standardized

exchange-traded contracts.

Options

Options are of two types - calls and puts. Calls give the buyer the right but

not the obligation to buy a given quantity of the underlying asset, at a given

price on or before a given future date. Puts give the buyer the right, but not

the obligation to sell a given quantity of the underlying asset at a given price

on or before a given date.

Swaps

Swaps are private agreements between two parties to exchange cash flows

in the future according to a prearranged formula. They can be regarded as

portfolios of forward contracts. The two commonly used swaps are

Interest rate swaps: These entail swapping only the interest related

cash flows between the parties in the same currency.


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Currency swaps: These entail swapping both principal and interest

between the parties, with the cash flows in one direction being in a different

currency than those in the opposite direction.

Swaptions

Swaptions are options to buy or sell a swap that will become operative at the

expiry of the options. Thus a swaption is an option on a forward swap.

Rather than have calls and puts, the swaptions market has receiver swaptions

and payer swaptions. A receiver swaption is an option to receive fixed and

pay floating. A payer swaption is an option to pay fixed and receive floating.

Other variants of Derivative Contracts are

Warrants

Leaps

Baskets

Warrants

Options generally have lives of up to one year the majority of options traded

on options exchanges having a maximum maturity of nine months. Longer-

dated options are called warrants and are generally traded over-the-counter.

Leaps

The acronym LEAPS means Long-Term Equity Anticipation Securities.

These are options having a maturity of up to three years.


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Baskets

Basket options are options on portfolios of underlying assets. The underlying

asset is usually a moving average of a basket of assets. Equity index options

are a form of basket options.

Participants

The following three broad categories of participants

Hedgers

Speculators

Arbitrageurs

Hedgers

Hedgers are interested in transferring risk associated with transacting orcarrying underlying physical asset. They use commodity futures to reduce or

limit the price risk of transacting underlying physical asset.

Speculators

Speculators are interested in making money by taking view on future price

movements. Commodity futures allow speculators to create high leveraged

position to undertake calculative risk with the objective of correctly

predicting the market movement.


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Arbitragers

Arbitragers are interested in locking in a minimum risk less profit by

simultaneously entering into transactions in two or more markets.

Arbitragers lock in profit when they spot cash and carry arbitrage

opportunity or reverse cash and carry arbitrage opportunity.

Function

Hedgers face risk associated with the price of an asset. They use futures or

options markets to reduce or eliminate this risk. Speculators wish to bet on

future movements in the price of an asset. Futures and options contracts can

give them an extra leverage; that is, they can increase both the potential

gains and potential losses in a speculative venture.

Arbitrageurs are in business to take advantage of a discrepancy between

prices in two different markets. If, for example, they see the futures price of

an asset getting out of line with the cash price, they will take offsetting

positions in the two markets to lock in a profit.

The derivatives market performs a number of economic functions.

First, prices in an organized derivatives market reflect the

perception of market participants about the future and lead the prices of


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underlying to the perceived future level. The prices of derivatives converge

with the prices of the underlying at the expiration of the derivative contract.

Thus derivatives help in discovery of future as well as current prices.

Second, the derivatives market helps to transfer risks from those

who have them but may not like them to those who have an appetite for

them.

Third, derivatives, due to their inherent nature, are linked to the

underlying cash markets. The underlying market witnesses higher trading

volumes because of participation by more players who would not otherwiseparticipate for lack of an arrangement to transfer risk.

Fourth, speculative trades shift to a more controlled

environment of derivatives market. In the absence of an organized

derivatives market, speculators trade in the underlying cash markets.

Margining, monitoring and surveillance of the activities of various

participants become extremely difficult in these kinds of mixed markets.

Fifth, an important incidental benefit that flows from

derivatives trading is that it acts as a catalyst for new entrepreneurial

activity.

The derivatives have a history of attracting many bright, creative, well-

educated people with an entrepreneurial attitude. They often energize othersto create new businesses, new products and new employment opportunities,

the benefit of which are immense. Finally, derivatives markets help increase

savings and investment in the long run. Transfer of risk enables market

participants to expand their volume of activity.


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Derivatives trading in India

The first step towards introduction of derivatives trading in India was the

promulgation of the Securities Laws (Amendment) Ordinance, 1995, which

withdrew the prohibition on options in securities. The market for derivatives,

however, did not take off, as there was no regulatory framework to govern

trading of derivatives.

SEBI set up a 24member committee under the Chairmanship of

Dr.L.C.Gupta on November 18, 1996 to develop appropriate regulatory

framework for derivatives trading in India. The committee submitted its

report on March 17, 1998 prescribing necessary preconditions for

introduction of derivatives trading in India. The committee recommended

that derivatives should be declared as securities so that regulatory

framework applicable to trading of securities could also govern trading of

securities.

SEBI also set up a group in June 1998 under the Chairmanship of

Prof.J.R.Varma, to recommend measures for risk containment in derivatives

market in India. The report, which was submitted in October 1998, worked

out the operational details of margining system, methodology for charging

initial margins, broker net worth, deposit requirement and realtime

monitoring requirements.

The SCRA was amended in December 1999 to include derivatives within the

ambit of securities and the regulatory framework were developed for

governing derivatives trading. The act also made it clear that derivatives


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shall be legal and valid only if such contracts are traded on a recognized

stock exchange, thus precluding OTC derivatives. The government also

rescinded in March 2000, the threedecade old notification, which prohibited

forward trading in securities.

Derivatives trading commenced in India in June 2000 after SEBI granted

the final approval to this effect in May 2000. SEBI permitted the derivative

segments of two stock exchanges, NSE and BSE, and their clearing

house/corporation to commence trading and settlement in approved

derivatives contracts. To begin with, SEBI approved trading in index futures

contracts based on S&P CNX Nifty and BSE30 (Sensex) index. This was

followed by approval for trading in options based on these two indexes and

options on individual securities.

The trading in index options commenced in June 2001 and the trading in

options on individual securities commenced in July 2001. Futures contracts

on individual stocks were launched in November 2001. Trading and

settlement in derivative contracts is done in accordance with the rules,

byelaws, and regulations of the respective exchanges and their clearing

house/corporation duly approved by SEBI and notified in the official gazette.

Commodity Future Trading

Introduction to commodity futures


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A commodity futures contract is an agreement between two parties to buy or

sell a specified quantity and quality of commodity at a certain time in future

at a certain price agreed at the time of entering into the contract on the

commodity futures exchange.

Objectives and benefits out of commodity futures are as follows

Hedging - price risk management by risk mitigation

Speculation - take advantage of favorable price movements

Leverage - pay low margin to enjoy large exposure

Liquidity - ease of entry and exit of market

Price discovery - for making farming and business decisions

Price stabilization along with balancing demand and supply position

Facilitates integrated price structure

Flexibility, certainty and transparency in purchasing commodities

facilitate bank financing.

Facilitates 'informed' lending to the banks

Need for Futures Trading in Commodities

Commodity Futures, which forms an essential component of Commodity

Exchange, can be broadly classified into precious metals, agriculture, energy

and other metals. Current futures volumes are miniscule compared to

underlying spot market volumes and thus have a tremendous potential in the

near future.


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1. Futures trading in commodities results in transparent and fair price

discovery on account of large-scale participations of entities

associated with different value chains. It reflects views and

expectations of a wider section of people related to a particular

commodity.

2. It also provides effective platform for price risk management for all

segments of players ranging from producers, traders and processors to

exporters/importers and end-users of a commodity.

3. It also helps in improving the cropping pattern for the farmers, thus

minimizing the losses to the farmers.

4. It acts as a smart investment choice by providing hedging, trading and

arbitrage opportunities to market players. Historically, pricing in

commodities futures has been less volatile compared with equity and

bonds, thus providing an efficient portfolio diversification option.

5. Raw materials form the most key element of most of the industries.

The significance of raw materials can further be strengthened by the

fact that the "increase in raw material cost means reduction in share

prices". In other words "Share prices mimic the commodity price

movements".


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6. Industry in India today runs the raw material price risk; hence going

forward the industry can hedge this risk by trading in the commodities

market.

Commodities Suitable for Future Trading

The following are some of the key factors, which decide the suitability of the

commodities for future trading: -

1. The commodity should be competitive

There should be large demand for and supply of the commodity

- no individual or group of persons acting in concert should be in a position

to influence the demand or supply, and consequently the price

substantially.

2. There should be fluctuations in price.

3. The market for the commodity should be free from substantial

government control.

4. The commodity should have long shelf life and be capable of

standardization and gradation.

Pricing of Future Trading Commodity


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Cost of carry M ethod

The relationship between cash price and futures price can be explained in

terms of cost of carry. Cost of storage, cost of insurance and cost of

financing constitute cost of carry. Cost of carry is an important element in

determining pricing relationship between spot and futures prices as well as

between prices of futures contracts of different expiry months.

When there is expected shortage of physical commodity in the future then

additional cost of holding the commodity is added to the spot price besides

cost of carry which is termed as Convenience Yield.

Basis and Spreads

Basis means difference between cash price of the asset and future price of

the underlying asset. Basis can be negative or positive depending upon

prices prevailing in cash market and future market.If cash price is less than future price than basis is negative.

If cash price is more than future price than basis is positive.

Spread means difference in prices of two futures contracts. Spread can be

classified as intra commodity spreads and inter commodity spreads. Intra

commodity spreads means difference in price between two futures contracts

of different expiry months of the same commodity. Inter commodity spread

means difference in price of two different commodities with same expiry

month.


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2.3 INTRODUCTION TO ARBITRAGE

A central idea in modern finance is the law of one price. This states that in a

competitive market, if two assets are equivalent from the point of view of

risk and return, they should sell at the same price. If the price of the same

asset is different in two markets, there will be operators who will buy in the

market where the asset sells cheap and sell in the market where it is costly.

This activity termed as arbitrage, involves the simultaneous purchase andsale of the same or essentially similar security in two different markets for

advantageously different prices (Sharpe & Alexander 1990). The buying

cheap and selling expensive continues till prices in the two markets reach

equilibrium. Hence, arbitrage helps to equalize prices and restore market

efficiency. Theoretical arbitrage requires no capital, entails no risk and

appears to be an easy way of earning profits. However, realworld arbitrage

calls for large outlay of capital, entails some risk and is a lot more complex

than the textbook definition suggests.

The science of arbitrage

Arbitrage pricing is one of the most important concepts in modern finance.

The origins of this lie in the efficient market hypothesis. In this section we

take a look at some literature on arbitrage and discuss the theory, operational

aspects and impediments to arbitrage.


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Efficient markets hypothesis

Efficient markets hypothesis states that the price of a security must be equal

to the expected present value of the future cash flows on that security. In

other words, it states that the price of a security must be equal to its

fundamental value. The two central assumptions of the efficient market

hypothesis are:

1. Investors hold rational expectations

2. Arbitrage brings prices towards fundamentals

In an efficient market there are no profitable arbitrage opportunities.

Proponents of the efficient markets hypothesis, like Fama (1965) and Ross

(2001) maintain that rational arbitrageurs will undo any mis-pricings in the

market. By buying under priced securities and selling overpriced ones,

arbitrageurs ensure that security prices converge to their fundamental values

thereby restoring market efficiency. However, the efficient market

hypothesis assumes that arbitrage strategies are risk less and do not involve

capital outlay. Hence professional arbitrageurs are willing to take unbounded

positions in the market. In reality however, arbitrage involves risk. An

arbitrage strategy is risky even if rational traders care only about the final

payoff of the arbitrage strategy. In other words, an arbitrage trade is risk less

only if a perfect substitute for the mis-priced asset exists. Arbitrageurs can

rarely fully hedge their arbitrage strategies. Recent literature on the limits to

arbitrage has identified two broad categories of risk:

1. Fundamental risk and

2. Noise trader risk.


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An arbitrage strategy can be risky because the fundamental value of a

partially hedged portfolio might change over time. Besides, the arbitrageurs

model may often not coincide with the true datagenerating process. Thus,

arbitrageurs have to bear fundamental risk even if they can sustain the

arbitrage strategy until the final payoff is realized.

In addition to this, the activity of behavioral noise traders might lead to

temporary price movements. These price changes temporarily reduce the

value of the arbitrage portfolio as prices move even further from

fundamental values. If arbitrageurs are compelled to liquidate their positions

in the intermediate term, then they are forced to take losses when the

arbitrage opportunity is greatest. This is called the noise trader risk.

In Shleifer & Vishny (1997), fund managers limit their arbitrage out of fear

of a drawdown. Fund managers are afraid that their investors will withdraw

their money if they suffer intermediate shortterm losses even though the

arbitrage provides a risk less positive payoff in the longrun. This paper

builds on the insight that distorted prices might become even more distorted

in the short run before eventually returning to their normal long run values.

Impediments to arbitrage

In its purest form, arbitrage requires no capital and is risk free (Dybvig &

Ross 1992). By simultaneously selling and purchasing identical assets at

different prices, the arbitrageur captures a profit with no upfront capital.

Unfortunately, pure arbitrage exists only in perfect capital markets. In the

real world, imperfect information and market frictions make arbitrage both

capitals intensive and risky. They impede arbitrage in two ways.


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1. When there is uncertainty over the nature of an apparent mis-

pricing, and additional learning involves a cost, arbitrageurs may be

reluctant to incur the potentially large fixed costs of entering the business of

exploiting the arbitrage opportunity (Merton 1987). Uncertainty over the

distribution of arbitrage returns, especially over the mean, will deter

arbitrage activity until wouldbe arbitrageurs learn enough about the

distribution to decide whether the expected payoff from the arbitrage is large

enough to cover the fixed costs of setting up shop. Even with active

arbitrageurs, opportunities may persist while the arbitrageurs learn to exploit

them.

2. Once the fixed costs of implementing the arbitrage strategy are

borne, imperfect information and market frictions often encourage

specialization. Specialization limits the degree of diversification in the

arbitrageurs portfolio and causes him to bear idiosyncratic risks for which

he must be rewarded. For instance, if there is a purely random chance that

prices will not converge to fundamental value, a highly specialized

arbitrageur who cannot diversify away this risk will invest less than one who

can. Even if prices eventually converge to fundamental values, the path of

convergence may be long and bumpy. While waiting for the prices of the

mis-priced securities to converge, they may temporarily diverge. If the

arbitrageur does not have access to additional capital when the security

prices diverge, he may be forced to prematurely unwind the position and

incur a loss (DeLong, Shleifer, Summers &Waldmann 1990), (Shleifer &

Summers 1990), (Shleifer & Vishny 1997). The prospect of incurring this

loss will further limit the amount that a specialized arbitrageur is willing to

invest.


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Capital intensive nature of arbitrage

Realworld arbitrage requires putting up huge capital for a short period of

time. Take the case of cash and carry arbitrage. In order to capture the mis-

pricing, the arbitrageur sells the overpriced futures, buys the underlying

stocks and holds them till the maturity of the futures contract. Buying the

underlying stock requires huge amount of capital. Very often due to lack of

capital, it is not possible for the arbitrageur to take delivery and hold stocks.

Hence small arbitrageurs are forced into intra-day arbitrage.

Arbitrage hinges on capturing profits due to mis-pricing on the market. The

underlying assumptions are that at some stage the mis-pricing will be wiped

out and prices will return to their fair value. This is when the arbitrageur

receives his profits. However it may often happen that prices do not correct

themselves immediately. There could be situations where the mis-pricing

worsens, in which case the arbitrageur would be required to bring in more

capital by way of margins. Even if eventually the prices of the two contracts

converge and the arbitrageur makes money, in the short run he loses money

and needs more capital. Arbitrageurs face difficulties in raising funds at

short notice. Very often an arbitrage strategy that is entered into is reversed

before the end of the contract. This is known as early unwind.

Operational issues in arbitrage

In situations where it is possible to exploit mispricing risklessly by

generating perfectly hedged positions and holding on to them till the final

payoff, the following operational aspects need be noted before entering into

an arbitrage.


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1. For the arbitrage to be a riskfree process, the arbitrageur must

trade simultaneously across two markets. In efficient markets, arbitrage

opportunities last for very short periods. As arbitrageurs spot these

opportunities and act upon them, the arbitrage gets wiped out. The fastest

instances of arbitrage opportunities being wiped out, are those seen in the

foreign exchange market. This market trades currency in large volumes, so

what seems like a small mispricing can often translate into huge profits.

2. Trading involves transactions costs. These transactions costs and other

market imperfections create a no arbitrage band around the fair value of an

asset. Hence the arbitrage opportunity must be sizeable enough to generate a

profit over and above the costs involved. Not all mispricings are profitable

arbitrage opportunities. However the potential returns net of transportation

costs and other overheads were clearly not attractive enough for arbitrageurs

to step in. Risks in arbitrage in India

The basic principles of an arbitrage strategy are straightforward if an asset

trades at two different prices across two markets, buy where it trades cheap

and sell where it trades expensive. This textbook arbitrage assumes a

frictionless world where arbitrage profits can be made without putting up

capital and without bearing any risk. In reality however, almost all arbitrage

requires capital and carries some risk. Shleifer & Vishny (1997) argue that

the textbook notion of arbitrage does not describe realistic arbitrage trades.

These discrepancies become particularly important when arbitrageurs

manage other people money. In India the risks become even more

pronounced due to existing market frictions.


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Arbitrage is an often-used term in share markets. The arbitrager is an

important intermediary that helps in price discovery mechanism in all

markets be it equity, money forex or derivatives. There are three important

participants that are important in a cash market, the speculator, arbitrager

and an investor. In futures market the investor is replaced by a hedger.

Arbitrager and Speculator are often confused and both are termed as

Speculators. In this article I wish to explain the difference between the two

and show how arbitrage works in the market and its influence on market

volatility. Arbitraging in India has been going on for several years. Initially

arbitrage activity was between Stock Exchange Mumbai and all other

regional exchanges. Mr. Babulal Bagri the founder of BLB Securities and

Mr. Manubhai Maneklal were legendary arbitragers of that era. They traded

between Mumbai, Delhi and Kolkatta markets. Arbitraging in those days

was done manually and not on any online system. The way the fingers of

these brokers flew on telex machines giving trade instructions was an

experience by itself. Then it shifted to cashing on price difference between

NSE and BSE limited. Today large amount of arbitrage happens between

cash and derivative markets. Arbitrage is also possible between the current

month and near or far month contracts. In case of Commodity exchanges

also there is an arbitrage opportunity between the local cash markets or

mandis and the future markets which are popularly known as National

Commodity Exchanges. Speculator is one who gives liquidity to the markets.

The buyers and sellers may not often decide at the same time to buy or sell a

security. There is a time gap as well as a difference in price and quantity at

which the buyer and seller intend to do a transaction. The speculator fills this

time gap and gives quotes to buyers as well as sellers on


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a continuous basis. This imparts liquidity to the market since each order has

a counter offer from a speculator even if there is no counter party to match

the order. The arbitrager is one who plays the role of balancing the price

differences across the markets. The markets may be two exchanges trading

in the same product or two segments such as cash and derivatives or across

international markets and local markets. The arbitrager continuously tracks

prices across the chosen segment are momentary price differences in two

markets due to difference in level of information as well as demand supply

situation in the market. These price differences are an opportunity for the

arbitrager. The arbitrager has money power at his disposal. He takes

deliveries in a particular market segment and is able to give deliveries in

another market segment. There is a time gap between giving and taking

deliveries. He holds the stock for this time and earns an interest on the funds

invested which comes by way of price differential between buy and sell

rates. The arbitrager has a particular interest return as his target. He does not

have any open positions and all his purchases or sells in a particular market

segment have a counter position in another market segment. At the net level

his position is always zero. This is how the arbitrager earns a risk free return.

The arbitrager does not always wait for the expiry of the contract or the

settlement of the transaction. They may reverse the position before the

actual settlement date even if they have to compromise on some percentage

of the price difference earned by them. Lesser return is acceptable if it is

earned with smaller or no investment. All decisions are taken with

reference to a benchmark targeted return To give example of an arbitrage

transaction, assume that the arbitrager has Rs.10 lacs available for doing

arbitrage activity. His targeted return is say 18% p.a. which works to about

1.5% p.m. We will take a simplistic transaction where he does just one trade


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to earn the return. If some share is quoting at Rs.1000 in one cash market he

will look for opportunity to buy at Rs.1000/- and sell at Rs.1015/- or more

in another cash market simultaneously. These markets must have different

settlement dates otherwise in current rolling settlement scenario it is not

possible to give and receive delivery since both happen on the same day.

Now the same example can be extended to cash and derivative segment.

Shares are purchased in cash market; and sold in futures market. Delivery of

the shares is received in the rolling settlement. Since deliveries are not

permitted in futures market a reversal pportunity is looked for before the

expiry of contract, otherwise the arbitrager will be left with the delivery of

shares. Hence if he gained say Rs.25 per share on the first leg he will reverse

the trade upto a loss of Rs.10 in order to achieve his benchmark return of

Rs.15. The returns are not often as fantastic but opportunities are many. We

also have to deduct from this the cost of brokerage, Securities transaction

tax, stock exchange charges and stamp duty. Hence it becomes unviable for

an investor unless the transaction costs are very low. The price difference is

only for a few minutes or seconds hence it must be captured instantly

through a speedy trading system. It should not so happen that one transaction

is done and the other one does not go through i.e. if the arbitrager buys and

is unable to sell and the market falls then instead of making a profit he will

end up with a loss. Automated trading programs are used in order to release

both orders so that both the prices are captured simultaneously.

Arbitrage activity thus adds to liquidity in the markets and also helps in

balancing the prices of same shares across various markets. Prices

continuously balance out once the differences are cash upon. Arbitrage helps

in reducing volatility in markets since continuous flow of orders reduces


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For example, suppose a futures contract is traded on two different

exchanges. If, Futures price = Spot price + Holding

F = S + C

However if

If F> (S + C) or F< (S + C), then arbitrage opportunity exists.

The futures price is calculated as follows:-

Example

Futures price of 100 gms of silver one-month down the line i.e. a contract

expiring 30th November is computed as follows:

What is the spot price of silver? The spot price of silver, S= Rs. 7000/kg

What is the cost of financing for a month? rT, cost of financing for a

month, 15% annualized = ln(1.15)*30/365

What are the holding costs? Assume storage cost, C = 0

The fair value of futures price, F=S*exp(rT) + C = 700 *

exp(ln(1.15)*30/365) = Rs. 708

If the contract was for a three-month period i.e. expiring on 30th January, the

cost of financing would increase the futures price. Therefore, the futures

price would be


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F = 700 * exp(ln (1.15)*90/365) = Rs. 725

In case of calculation of the price of future contracts on equities there is no

cost of storage considered in holding paper, however equity paper comes

with a dividend stream, which is a negative cost if you are long on the stock,

and a positive cost if you are short the stock.

C = financing cost - dividends

Thus, a crucial aspect of dealing with equity futures as opposed to

commodity futures is an accurate forecasting of dividends. The better the

forecast of dividend offered by a security, the better is the estimate of the

futures price.

For example

What is the fair value of a two-month S&P CNX Nifty futures contract

expiring on April 25?

What is the annual dividend yield on S&P CNX Nifty index? The dividend

yield on S&P CNX Nifty, 2% annualized = ln(1.02)*60/365

What is the spot value of S&P CNX Nifty? Current value of S&P CNX

Nifty is 910

What is the cost of financing for two months? RT, cost of financing for a

month, 15% annualized = ln(1.15)*60/365

What are the holdings costs? Assume storage cost, C=0


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The fair value of futures price, F=S*exp(ln(1+r-q))*T + C = 910 *

exp(ln(1.13)*60/365) = Rs. 928.47

Arbitrage helps investors to lend funds into the stock market, without

suffering the slightest risk. In the traditional methods of loaning money into

the stock market there is a price risk or credit risk involved. But through the

index futures market an investor can hedge both the price and credit risk.

The basic idea is simple. The lender buys all 50 stocks of S&P CNX Nifty

on the cash market, and simultaneously sells them at a future date on the

futures market. There is no price risk since the position is perfectly hedged.

There is no credit risk since the counter party on both legs is the National

Securities Clearing Corporation (NSCC) which supplies clearing services on

NSE. It is an ideal lending vehicle for entities which are shy of price risk and

credit

risk, such as traditional banks and the most conservative corporate treasuries.

Hedging the Price Risk

One buys a portfolio in which all the 50 stocks in S&P CNX Nifty are in

correct proportion, (i.e. where the money invested in each stock is

proportional to its market capitalization.) on the cash market. Simultaneously

sell S&P CNX Nifty futures of equal value. Now you are completely

hedged, so fluctuations in S&P CNX Nifty do not affect you.A few days

later, you will have to take delivery of the 50 stocks and pay for them. This

is the point at which you are "loaning money to the market".Some sell your

portfolio and reverse your future position. A few days later, you will have to


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make delivery of the 50 stocks and receive money for them. This is the point

at which "your money is repaid to you".The interest rate that you will

receive is the difference between the futures price and the cash S&P CNX

Nifty plus any dividends earned minus the transactions costs (impact cost,

brokerage) in doing these trades.

Suppose the S&P CNX Nifty spot is at 1000 and the two-month futures are

at 1040. Suppose the transactions costs involved are 0.4% per month and

dividends over the two months are nil. Then the rate of return in loaning

money to the market is 1.5% (1040/1000 over two months is near 1.9% per

month. Subtract out 0.4% as transaction costs to get 1.5% per month.

On 1 August, S&P CNX Nifty is at 1200. A futures contract is trading with

27 August expiration for 1230. Ashish wants to earn this return (30/1200 for

27 days).

He buys Rs. 3 million of S&P CNX Nifty on the spot market. In doing this,

he places 50 market orders and ends up paying slightly more. His average

cost of purchase is 0.3% higher, i.e. he has obtained the S&P CNX Nifty

spot for 1204.

He sells Rs. 3 million of the futures at 1230. The futures market is extremely

liquid so the market order for Rs. 3 million goes through at near-zero impact

cost. He takes delivery of the shares and waits.

While waiting; a few dividends come into his hands. The dividends work out

to Rs. 7,000.


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On 27 August, at 3:15, Ashish puts in market orders to sell off his S&P CNX

Nifty portfolio, putting 50 market orders to sell off all the shares. S&P CNX

Nifty happens to have closed at 1210 and his sell orders (which suffer impact

cost) goes through at 1207.

The futures position spontaneously expires on 27 August at 1210 (the value

of the futures on the last day is always equal to the S&P CNX Nifty spot).

Ashish has gained Rs. 3 (0.255) on the spot S&P CNX Nifty and Rs. 20

(1.63%) on the futures for a return of near 1.88%. In addition, he has gained

Rs. 7,000 or 0.23% owing to the dividends for a total return of 2.11% for 27days, risk free.

Arbitrage also offers an investor the opportunity to lend securities to the

market and earn revenues. The mechanism is simple -you sell off your

certificates and contract to buy them back in the future at a fixed price. The

basic idea is quite simple. You would sell all 50 stocks in S&P CNX Nifty

and buy them back at a future date using the index futures. You would soon

receive money for the shares you have sold. You can deploy this money as

you like until futures expiration. On this date, you would buy back your

shares, and pay for them.

Suppose you have Rs. 5 million of the S&P CNX Nifty portfolio (in their

correct proportion, with each share being present in the portfolio with a

weight that is proportional to its market capitalization).

Sell off all 50 shares on the cash market. This can be done using a single

keystroke (offline order entry) using the NEAT software.


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Buy index futures of an equal value.

A few days later, you will receive money and have to make delivery of the

50 shares.

Deploy this money at the riskless interest rate.

On the date that the futures expire, at 3:15 PM, put in 50 orders (using

NEAT again) to buy the entire S&P CNX Nifty portfolio.

A few days later, you will need to pay in the money and get back your

shares.

This is possible when the spot-futures basis (the difference between spot

S&P CNX Nifty and the futures S&P CNX Nifty) is smaller than the riskless

interest rate that you can find in the economy. If the spot-futures basis is

2.5% per month and you are loaning out the money at 1.5% per month, it is

not profitable. Conversely, if the spot-futures basis is 1% per month and you

are loaning out money at 1.2% per month, this stocklending could be

profitable.The stock lending rate is calculated as follows:- we assume that

transactions cost account for 0.4%. Suppose the spot-futures basis is x% and

suppose the rate at which funds can be invested is y%. Then the total return

is y - x - 0.4%, over the time that the position is held.

Example

Suppose Akash has Rs. 4 million of the S&P CNX Nifty portfolio which he

would like to lend to the market.


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Akash puts in sell orders for Rs. 4 million of S&P CNX Nifty using the

feature in NEAT to rapidly place 50 market orders, in quick succession. The

seller always suffers impact cost; suppose he contains an actual execution at

1098.

A moment later, Akash puts in a market order to buy Rs. 4 million of the

S&P CNX Nifty futures. The order executes at 1110. At this point, he is

completely hedged.

A few days later, Akash makes delivery of shares and receives Rs. 3.99

million (assuming an impact cost of 2/1100)

Suppose Akash lends this out at 1% per month for two months.

At the end of two months, the money comes back to him as Rs. 4,072,981.

Translated in terms of S&P CNX Nifty, this is1098 * 1.012 or 1120.

On the expiration date of the futures, he puts in 50 orders, using NEAT,

placing market orders to buy back his S&P CNX Nifty portfolio. Suppose

S&P CNX Nifty has moved up to 1150 by this time. This makes shares

costlier in buying back, but the difference is exactly offset by profits on the

futures contract.

When the market order is placed, suppose he ends up paying 1153 and not

1150, owing to impact cost. He has funds in hands of 1120, and the futures

contract pays 40 (1150-1110) so he ends up with a clean profit, on the entire

transaction, of 1120+40-1153 = 7. On a base of Rs. 4 million, this is Rs.

25,400


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Some of the risks associated with arbitrage

Risks in arbitrage in India

The basic principles of an arbitrage strategy are straightforward if an asset

trades at two different prices across two markets, buy where it trades cheap

and sell where it trades expensive. This textbook arbitrage assumes a

frictionless world where arbitrage profits can be made without putting up

capital and without bearing any risk. In reality however, almost all arbitrage

requires capital and carries some risk. Shleifer & Vishny (1997) argue that

the textbook notion of arbitrage does not describe realistic arbitrage trades.

These discrepancies become particularly important when arbitrageurs

manage other people money. In India the risks become even more

pronounced due to existing market frictions.

Some of the risks associated with arbitrage

Execution lags

In the ideal world, trades placed to capture an arbitrage opportunity would be

instantaneously executed. However, in the real world, execution takes time.

Very often, there can be variations in price between the time an arbitrage

opportunity is entered into and the time the trade is actually executed on the

market. There could be a slow down or halt in trading due to illiquidity or

market congestion. This slippage naturally increases when markets are

volatile.

Interest rate uncertainty


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An arbitrageur who enters into an arbitrage trade assumes that a particular

level of interest rate will remain constant. In the cashandcarry strategy, the

arbitrageur assumes that he will be able to borrow at a certain rate till the

expiration of the futures contract. Similarly, in the reversecashandcarry

strategy, he assumes that he will be able to invest the proceeds from the sale

of stocks at a particular rate of interest. However, the uncertainty about the

interest rate that will be charged on the capital that is deployed and the

returns that would be generated from the free funds deployed in the money

market, have a direct bearing on the profits generated from arbitrage

positions undertaken.

Futures spread

A futures spread position is constructed by purchasing a long position in

futures contract and selling a short position in another one simultaneously to

exploit the temporary disequilibrium between them. A spread trader

anticipates making a profit from correctly predicting the relative price

movements between two futures contracts. In general, trading spread is less

risky than trading straight positions because both contracts tend to move in

the same direction, so most of the market risk is offset by opposite positions.

Futures spreads can be divided into three varieties:

Inter - month,


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Inter - commodity

Inter month or calendar spread consists of offsetting positions in two or more

maturities of the same futures contract..

For example, a spreader buys a March and sells June Chana futures. Such

spreads represent speculation on the basis which is the difference between

the futures price and the cash price.

Inter market spread is made up of offsetting positions in different futures

markets but the same commodity, usually in the same delivery month. An

inter market spread, for instance, can be constructed between the Chana

futures in MCX and NCDEX.

As the two futures have the same delivery date, they must both have the

same value of the underlying commodity at delivery. In fact, such spread

trading results in a risk less arbitrage, called spread arbitrage (Board and

Sutcliffe, 1996).

Inter commodity spread involves different commodities, whether in the same

delivery month or not. Not all such combinations can be considered as

spreads. There must be a reasonable linkage in the prices of the two

commodities, and the linkage must be direct for a spread to be a recognized

spread. Recognized inter commodity spreads include corn versus wheat,

soybeans versus end products (oil and meal), and gold versus silver.

The common thread running through such spreads is that each set of long

and short positions are affected by the same factors of supply and demand

(Herbst, 1992, p.31). The literature on inter commodity spreading trading is

not extensive owing to the complexity of the inter commodity spread


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relationships. Inter commodity futures spreads are often constructed through

a production process. Refiners and processors use these spreads to deal with

operating risk, while arbitrageurs use them to get profits when the

commodity prices falls outside the no-arbitrage conditions implied by the

production process.

2.4 INTRODUCTION TO COMMODITY GOLD

In the last 6,000 years a little over125,000 tonnes of gold has been mined.

But this history is clearly divided into two eras - before and after the

California gold rush of 1848. Some calculations suggest that up until then


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scarcely 10,000 tonnes of gold had been excavated since the beginning of

time. Thus more than 90% of the worlds gold has been produced since

1848. Early gold mining by the Egyptians, from around 2000 BC, (in the

areas which are now Egypt, the Sudan and Saudi Arabia), is thought to have

produced no more than 1 tonne annually. Perhaps 5-10 were produced

during the time of the Roman Empire, (mainly from Spain, Portugal and

Africa), but in the Dark and Middle Ages (500-1400 AD) production, from

the mountains of central Europe, probably fell back to less than a tonne.

Throughout all this time gold was also being mined and worked in South

America, where the goldsmiths art reached very high standards. From the

middle of the 15th century the Gold Coast of West Africa (now known as

Ghana) became an important source of gold, providing perhaps 5-8 tonnes

per year. In the early 16th century the Spanish conquests of Mexico and Peru

opened up a further source of gold. By the close of the 17th century, 10-12

tonnes a year were provided by the Gold Coast and South America together.

Gold was first discovered in Brazil in the mid-16th century but significant

output did not emerge until the early 18th century. Towards the end of that

century, considerable supplies began to come from Russia as well, and

annual world production was up to 25 tonnes. By 1847, the year before the

Californian gold rush, Russian output accounted for 30-35 tonnes of the

world total of about 75 tonnes. The gold rushes, and later the South African

discoveries, radically altered the picture but Russian production continued to

rise, reaching around 60 tonnes in 1914. The crucial turning point in the

history of the gold mining industry came with the discovery at Sutters Mill

on the American River in January 1848, which ushered in a new age of gold.

Gold mining now took on a quite different dimension. Output from

California soared, reaching 77 tonnes in 1851 (the year gold was also


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discovered in Australia) and peaked in 1853 at 93 tonnes. The Australian

find triggered a gold rush there, which reached a climax in 1856 with 95

tonnes. World production at this time climbed to 280 tonnes in 1852 and

thence to almost 300 tonnes as Australia flourished. Production was lifted on

to an even higher plane in 1886 with the discovery of the huge gold reefs in

the Witwatersrand Basin of South Africa. Gold had first been found in

eastern Transvaal in 1873, but from the outset it was obvious that the

Witwatersrand deposits were of a completely different order. South Africa

ousted the United States as the worlds premier producer in 1898, a position

it has held almost continuously ever since. From 1884, the first year of

recorded output, South Africa has been the source of close to 40% of all the

gold ever produced. The most productive year was 1970 when over 1,000

tonnes were mined, representing more than three-quarters of western world

output. While the South African gold mining industry was ta

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