How can arbitrage funds adapt to changing volatility?

Arbitrage funds are relatively low-risk investment options that aim to generate returns by capitalising on the price difference between the same asset or security in two different markets or segments – such as spot and futures.

This article discusses how arbitrage fund categorised as hybrid funds can adapt to change in market using various strategies.

• Table of contents

1. Understanding volatility in the market
2. Challenges faced by arbitrage funds in changing volatility
3. Strategies to adapt to changing volatility

Understanding volatility in the market

Volatility refers to the variation in the price of a stock over a given period. It represents how uncertain or risky the market is with respect to the movement of stock prices. High volatility suggests greater uncertainty and risk associated with the movement in stock prices.

Additionally, factors like increasing inflation, rising interest rates, fears of recession, and geopolitical tensions also contribute to market volatility. During periods of high volatility, the gap between cash and futures prices widens as market participants hedge their positions or carry out speculative trades.

While large price discrepancies provide potential opportunities for arbitrage trades, they also pose certain risks. There is a chance of potential losses for arbitrage funds if the prices move against their positions before they can close out trades. Also, sustained high volatility can narrow down the number of opportunities available as more participants try to benefit from the wide divergences. This creates challenges for generating a consistent return potential.

Challenges faced by arbitrage funds in changing volatility

• Reduced trading opportunities: During volatile periods, arbitrage opportunities can dry up if many participants try to exploit the wide price gaps. This shrinks the trading bandwidth.
• Widened trading range: Higher volatility may increase the risk of unfavourable market movements against open arbitrage positions.
• Higher capital requirement: Volatile markets may require arbitrage funds to deploy larger capital to take advantage of opportunities. This ties up more funds.
• Liquidity risk: In a sell-off, the ability to square off positions in a short time span is challenged due to reduced liquidity. This may potentially increase losses.
• Margin requirements increase: Leveraged positions needed by arbitrage trades become relatively riskier in turbulent times. Funds may have to reduce exposures if unable to meet higher margin costs.

Strategies to adapt to changing volatility

• Maintain adequate liquidity: Funds should keep sufficient cash reserves to easily cover margins and square off trades without facing liquidity issues. This also helps tap into opportunities quickly.
• Diversify strategies: In addition to traditional index and cash-futures arbitrage, funds can employ new strategies like stock pair trading, and intra-day trading.
• Mitigate risk through hedging: Hedging techniques like index futures, stock futures, and options can be used to insulate positions from unfavourable price movements.
• Deploy algorithmic tools: Technology tools like algorithmic trading based on volatility indicators help detect opportunities, control risks and enhance the efficiency of arbitrage execution.
• Trade shorter timeframes: Opportunistic short-term and intra-day trades that do not require large exposures are preferred over long-term trades that are risky.
• Manage leverage prudently: Leverage levels can be dynamically adjusted based on volatility forecasts rather than maintaining fixed leverage throughout.
• Maintain flexibility in trade sizes: The ability to experiment with low to high trade sizes based on risk-adjusted returns and volatility may allow optimum utilisation of opportunities.

Conclusion

The above information shows how arbitrage funds adapt to changing volatility. Arbitrage funds can proactively adjust their trading strategies based on changing market volatility to manage risks and generate alpha. The approach involves liquidity management, risk hedging and leveraging technology. This can potentially help arbitrage funds deliver low-risk returns.

Individuals looking to invest in this type of fund may consider Bajaj Finserv Arbitrage Fund. The investment objective of the scheme is to seek to generate returns by investing in arbitrage opportunities in the cash and derivatives segments of the equity markets and by investing balance in debt and money market instruments. However, there is no assurance that the investment objective of the Scheme will be achieved.

FAQs

What risk management techniques are employed by arbitrage funds in volatile markets?

Arbitrage funds try to remain market neutral by balancing long and short positions that can potentially gain from price discrepancies, rather than taking on directional market risk. They closely monitor positions and use stop-losses to automatically exit trades if prices move too far in the unwanted direction in order to limit downside exposure.

Is there any risk associated with arbitrage funds?

While comparatively less risky than pure equity funds, arbitrage funds carry certain risks such as market risk, liquidity risk, counterparty risk, and management risk.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully.
This document should not be treated as endorsement of the views/opinions or as investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document is for information purpose only and should not be construed as a promise on minimum returns or safeguard of capital. This document alone is not sufficient and should not be used for the development or implementation of an investment strategy. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision. Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals and horizon. This information is subject to change without any prior notice.