What are Arbitrage Funds? How do They Work?

Akin to debt funds, the arbitrage funds come with a risk-return profile and tax benefits. In terms of returns, the arbitrage funds work like liquid debt funds and are also largely risk-free.

What is arbitrage? What are arbitrage funds?

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Arbitrage is an investment practice in which the investor tries to capture the price differences of a product or asset in two different markets. So, the returns come from buying the investment product from one market at a lower price and selling the same in another one where the price is higher. This practice is also called “arbitrage opportunity”.

The funds used for arbitrage are called arbitrage funds. Given below is an example how they are used:

Say, the share price of a company Zee Electronics is quoted at Rs. 5,000 per share in the National Stock Exchange (NSE), and Rs. 5,500 at the Futures & Options (F&O) market. So, if you buy four shares from the NSE and then sell the same in F&O, you make a profit of Rs. 2,000 (Rs. 500 profit from each share).

What are the tax implications of arbitrage funds?

The income tax on arbitrage funds can be calculated by understanding their relationship with long-term gains and short-term gains:

Long-Term Capital gains

If you hold an arbitrage mutual fund for more than a year and make a profit on the same, then it’s considered a long-term capital gain.

Long-term capital gains get 100% tax deduction.

Short-Term Capital gains

If you withdraw an arbitrage mutual fund within a year, then the capital gain is considered a short-term capital gain. These attract a tax rate of 15%.

It’s also worth noting that debt mutual funds also attract a tax rate of 30% for short term capital gains when withdrawn within 3 years.

Note: Arbitrage funds are best to be invested in when the markets are volatile and unstable. This is because there is a high chance of earning huge dividends during this period.