Originally posted by smartcat Do you have any idea about how this arbitrage trading results in such huge gains? I don't think it is like JM Equity & Derivative Fund type of arbitrage trading - because they hardly give 8% annual returns.

It is a little difficult to describe in a short message.

Broadly speaking, there are three different types of market related risks that one takes in equity trading:

1.  Directional risk

2.  Volatility Risk

3.  Correlation risk

Those who bet long or short are essentially running the directional risk.

However, one could neutralize the directional risk and just isolate the other two risks. 

For instance, a simple pair trading strategy (think of going long Infy and shorting TCS, for example), would not run either directional or volatility risk, but isolates only the correlation risk.

Another example would be selling volatility (i.e., writing an option) and "delta hedging" in the corresponding stock futures.  This position would not have either directional or correlation risk.  It will isolate  only volatility risk.

When one talks about arb strategies, generally one is referring to  strategies that do not entail directional risk but has only either correlation or volatility risk.   One needs sophisticated models to develop these strategies, execute and monitor them.   Edelweiss has the "best of breed" models and strategies.

The simple "cash-futures arb" is often referred to as "pure arbitrage" as it neutralizes all three types of risk.  That is why, most often, these cash-future arbs produce a return only slightly better than the risk free rate.  I havn't followed the JM Financial strategy but if they are producing 8%, it is likely they are engaging in mostly cash-futures arb strategies.

In India, the futures and options markets are still in their infancy.  So, the volatility and correlation risks are still not priced efficiently.  This opens up avenues for building trading strategies to exploit the differences.  Edelweiss does this well, as far as I know.   

Fast growing economies often have to contend with a fast rising currency. In India, the year-on-year rise of the rupee right now more or less matches the GDP growth figure, and there is little reason to expect the trend not to be sustained. For the corporate sector that must deal with the commercial world beyond Indian borders, this means having to take fresh guard. A strengthening rupee could easily mean getting priced out of markets overseas. The implications are particularly severe for the small and medium enterprises that form the largest component of the export basket. If there is anything they need desperately at the moment, it is not a goodie bag of sops from the government, but a workable domestic platform for the trading of currency futures. This can form part of a hedging strategy to protect earnings from currency movements. Hedging in the forwards market is a stock-in-trade for big business nowadays. It is the smaller players, who are more vulnerable to shifts in the economic environment, who need access to similar instruments within the domestic financial sector. Expecting them to use platforms overseas is unrealistic.

There are, of course, other components of a hedging strategy that are accessible to SMEs. Several exporters, for example, are trying to renegotiate deals in alternate currencies. Even rupee contracts are no longer unheard of, and not just to former Soviet bloc markets. Besides that, “invoicing flexibility” has been a special characteristic of Indian exports down the decades, and there are some signs that some of the old devices are being deployed again (not all of them strictly honourable, one should add). Other forms of shipment and order juggling are also in increasing practice. A somewhat robust strategy, for example, may involve the use of warehouse space on a long-term basis in the EU and US. Some operational outsourcing to other locations may also take place, as the production chain goes global for optimal efficiency. This could imply more capital outflows, but then, India is not afraid of that any longer. The government, which is sitting atop a pile of foreign exchange reserves, should be pleased with this trend. In all, a successful defence for exporters against the ravages of a rising rupee always requires a higher degree of worldly wisdom. This can only be good for Indian business as the world globalises furiously.

Edited by basant - 13/Dec/2009 at 9:27am

this looks like being done with very clever software

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