Definition
An Arbitrage Fund is a type of mutual fund that profits from price differences in the value of identical or similar financial instruments on different markets or in different forms. The fund capitalizes on these discrepancies without the risk or actual delivery of the underlying securities or commodities. In other words, it exploits market inefficiencies for a risk-free profit.
Key Takeaways
- Arbitrage Fund is a type of mutual fund that leverages the price differential in the cash and derivatives market to generate returns. The fund capitalizes on price discrepancies between current and future security prices.
- Arbitrage Fund typically has lower risk and volatility as compared to regular investment funds. They profit from market inefficiencies without predicting market directions, making them less exposed to market fluctuations.
- Despite the lower risk, Arbitrage Funds are not risk-free. They depend on the volatility and predictability of financial markets. If their predictions go wrong, they have the potential for losses.
Importance
Arbitrage Fund is an important finance term as it describes a type of investment fund that seeks to profit from price differences of identical or similar securities, from different markets or in different forms.
It is essential because it offers investors a hedge against market volatility, which makes it a favorable choice for risk-averse investors.
Also, it allows investors the opportunity for potential profit regardless of market trends, due to its underlying strategy of buying low in one market and selling high in another.
It strikes a balance between risk and return, making it a pivotal part of investment and finance landscape.
Explanation
The primary purpose of an arbitrage fund is to leverage price differences in the market. Such discrepancies can occur for a variety of reasons, which could be different prices for the same asset in distinct markets or price disparity among related securities.
Traders and investors use arbitrage funds to exploit these variations and attempt to lock in risk-free returns. An arbitrage fund can serve as an effective hedge against market volatility, which is why it is often incorporated into a diversified investment portfolio.
This is possible since arbitrage opportunities can arise irrespective of the overall market conditions. Moreover, these funds tend to have a lower risk compared to other investments due to their reliance on market inefficiencies rather than the market performance to generate returns.
This characteristic can make them attractive to more risk-averse investors.
Examples of Arbitrage Fund
Currency Arbitrage: This is typically used in the foreign exchange market. For example, a trader could buy British pounds with US dollars when the exchange rate in the US is more favorable than it is in the UK. After purchasing the pounds, the trader can then sell them back for US dollars in the UK at a higher exchange rate, making a profit due to the difference in prices.
Merger Arbitrage: This strategy is typically used when a company has announced it is being acquired. For example, if Company A announces it is buying Company B, an arbitrage fund could purchase shares of Company B while selling short shares of Company A to try to profit from the spread between the current market price and the acquisition price of Company B.
Convertible Bond Arbitrage: In this strategy, an arbitrage fund could take advantage of pricing inefficiencies between a company’s convertible bonds and its stock. For instance, when a convertible bond is undervalued compared to the stock, the fund could purchase the convertible bond and sell short the stock. If the prices converge, the fund could realize a profit. In all of these examples, the idea is to exploit price differences between related securities to profit without taking on a significant amount of risk.
FAQs about Arbitrage Fund
What is an Arbitrage Fund?
Arbitrage Fund is a type of mutual fund that takes advantage of pricing differences in different markets. It involves simultaneous buying and selling of shares in different markets, so as to profit from the difference in prices of the same security.
How does an Arbitrage Fund work?
An Arbitrage Fund works by purchasing a security in one market and simultaneously selling it in another market where the price is higher, thus profiting from the price difference. The Fund manager applies this strategy with a goal of capitalizing on the price differential without much risk.
What are the benefits of an Arbitrage Fund?
The benefits of an Arbitrage Fund include generating profits from market inefficiencies, market neutral strategies that help in minimizing risk, and potential tax efficiency due to treated as equity funds for tax purposes.
Who should invest in an Arbitrage Fund?
Arbitrage funds are suitable for investors who want to take advantage of market volatility without taking too much risk. It is also suitable for investors looking to make short term investments while mitigating risk and volatility.
Are there any risks associated with Arbitrage Funds?
While Arbitrage Funds are considered to be safer than regular equity funds, they are not entirely risk-free. Some of the risks include execution risk and opportunity risk. However, the total risk involved is relatively lower than many other types of investments.
Related Entrepreneurship Terms
- Hedge Funds
- Arbitrage Pricing Theory (APT)
- Mergers and Acquisitions (M&A)
- Risk Arbitrage
- Market Efficiency
Sources for More Information
- Investopedia: Investopedia provides an exhaustive and comprehensible resource database for all finance-related terms including Arbitrage Fund.
- Morningstar: Morningstar presents detailed analyses and ratings on funds, including Arbitrage Funds.
- Moneycontrol: Moneycontrol provides the latest information and articles on Arbitrage Funds.
- Fidelity: Fidelity has in-depth resources and tools for understanding all sorts of funds, including Arbitrage Funds.
