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Trend of Arbitrage spread and return
 

  • The difference between future price and spot price of the underlying asset is known as basis.
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  • In equity arbitrage, basis (difference) is due to the cost of carry1 (spread).
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  • Normally basis is positive i.e. future price is higher than the spot price of the underlying asset and investor will sell the underlying asset in future market and buy in the cash market.
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  • When there is negative basis reverse of the above takes place. Therefore theoretically investor can make a positive return whether there is a positive or a negative basis.
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  • Chart below shows Nifty futures average monthly and average rollover spreads.
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Nifty Future Average

 

  • From the above chart, we can see that in both cases normally there is a positive spread.
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  • Investor doing arbitrage when average spread of Nifty future was 32.24 highest in March 2012 would have made average return of 7% annualized.
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  • Similarly, if he had rolled over his futures contract taking advantage of the average spread of 53.75, average return would be 12.11% annualized.
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  • As seen, spreads are volatile every month and hence returns too earned are volatile monthly.
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  • Chart below shows Nifty futures rollover average 6 months rolling returns2 from June 2011 to June 2013.
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Nifty Futures rollover 6 months average

 

  • From above chart, we can observe that over 6months returns smoothen out and one gets average return of between 6 to 8%.
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  • Chart below shows Nifty futures rollover average 1 year rolling returns from June 2011 to June 2013.
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Nifty 1 year average rolling return

 

  • From above chart, we can observe that returns further smoothen out during 1 year investment horizon.
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Rollover of futures contract
 

  • When expiry date nears, investors start squaring off their positions and if arbitrage opportunity exist they rollover their futures contract.
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  • The demand and trend for the underlying asset can be understood with open interest.
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  • Open interest (OI) is the total number of future contracts not closed out on particular day i.e. contracts which have purchased or outstanding on that particular day.
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  • Chart below shows OI for expiry month and rollover.
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OI for expiry month & rollover

 

  • From the above chart, we can see the contracts towards expiry OI for current month (in purple) declines and rollover (in orange) month increases showing investors rolling over their future contracts.
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  • Decline in roll over OI shows investors have squared off their positions instead of rolling over. This is seen during March 2013 expiry as OI have declined for April 2013 contract.

 

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