Arbitrage Funds Explained: How They Work in India

Arbitrage funds are one of the lowest-risk mutual fund categories in India, yet most investors do not fully understand how they generate returns. We mentioned arbitrage funds as a tax-efficient alternative in our guide on saving tax on savings account interest. In this post, we cover how arbitrage funds work, the cost-of-carry model, forward and reverse arbitrage, taxation, and the top-performing funds ranked by returns.

An arbitrage fund is a hybrid mutual fund that maintains at least 65% of its portfolio in equity. It generates returns by exploiting the price gap between the cash market and the futures market for the same stock.

How an Arbitrage Fund Works — HDFC Bank Example

For example, HDFC Bank's current cash market price is ₹725, and its September futures are trading around ₹734. The lot size for HDFC Bank futures is 650, so the total investment needed to buy the shares is ₹4,71,250 (650 × 725). Selling the futures requires a margin of around ₹65,500, which can be reduced by half if the ₹4,71,250 worth of shares is pledged. The remaining half, around ₹33,000, needs to be kept in cash or cash equivalents such as government securities.

The difference between the cash and futures price is about ₹9, and 650 × 9 is around ₹5,850. After deducting charges of around ₹250, the net gap is roughly ₹5,600. The logic is that at expiry, the gap between the futures and cash price shrinks and both converge — regardless of whether the stock moves up 10% in a single month or falls by 15% or 25%. If the stock rises, the futures also rise, and if it falls, the futures also fall — but the gap remains and narrows as expiry approaches.

In summary, the total amount needed to implement this trade is around ₹5,50,000 (₹4,71,250 for shares plus around ₹65,500 in margin). You can earn roughly ₹5,600 in about 40 days — approximately 1% per month. Annualized, that works out to around 12% in this scenario.

September 2026 Cash vs Futures Data

In the HDFC Bank example above, market volatility is relatively low. However, some F&O stocks are more volatile, and in those cases the gap between cash and futures can be wider, producing a higher return. Below are the top 10 Nifty 50 stocks with the cash-futures gap. This return is only possible when the gap is positive — if the gap is negative, the trade does not work.

All figures are approximate and shown for illustration only. Total amount includes shares plus margin.

The Cost of Carry Model

The theoretical futures price of any stock follows the cost of carry model.

F = S × (1 + r − d)ᵗ

• S → cash market price (spot)
• r → risk-free interest rate
• d → dividend yield
• t → time to expiry

What is the role of r and d here?

r represents the risk-free interest rate, similar to the rate on a treasury bill. It adds a premium to the futures price because buying futures requires only a margin, not the full stock price. If futures traded at the same price as cash, a trader could buy futures and invest the remaining capital in a bank to earn interest until expiry — free profit. To prevent that, the market prices in an interest-rate premium. d (dividend yield) is subtracted because dividends are paid to stockholders but not to futures holders. The formula reduces the futures price by the dividend yield to account for that benefit the cash buyer receives.

The spread is approximately the interest rate minus the dividend yield. The spread tends to widen when interest rates are high and dividend yields are low, and also early in the expiry cycle when the time to expiry is longer. Conversely, the spread can turn negative for high dividend-paying stocks near their record date. When a stock is in a downtrend, heavy short selling in futures at a price lower than the cash price compresses the futures price. If short selling is restricted in the cash market, it becomes difficult to close the gap. Also, if the Securities Lending and Borrowing (SLB) facility is not available for a stock due to low demand, the arbitrage opportunity can shrink or disappear.

Forward Arbitrage vs Reverse Arbitrage

The normal scenario discussed above is called forward arbitrage. In reverse arbitrage, the futures price is lower than the cash price. To capture the difference, you buy futures and sell the stock. For example, LIC in the table above shows futures at ₹411.80 against a cash price of ₹412.15 — a negative gap of ₹0.35. LIC's dividend yield is among the highest in the Nifty 50 at around 2.4%, and when the dividend yield (d) exceeds the effective risk-free rate (r) for the remaining expiry period, the cost-of-carry formula pushes futures below the cash price.

In India, naked short selling of a stock is not allowed. So a trader must sell existing holdings and buy futures to capture the gap — but that futures position is unhedged. If the futures price drops further, the trader faces a loss on the futures as well. However, since futures eventually converge with the cash price at expiry, the loss is typically limited to the remaining gap.

At expiry, the trader can take delivery of the shares and hold them, or sell if in profit. However, short selling in the cash market beyond intraday is not allowed in India. To hold a short position overnight, the trader must borrow the stock through SLB and buy futures, provided the cash price is higher than the futures price.

Reverse Arbitrage Works for the Index but Not Easily for Stocks

Reverse arbitrage requires selling the underlying stocks. For the index, arbitrage funds already hold stocks in proportion to the index, so selling them is easier than selling a single stock. If a specific stock is not available in sufficient quantity, the fund must borrow it through SLB, which requires paying interest. Index futures are also more liquid than single-stock futures. If futures are trading below the cash price, the fund can exit its cash index positions and buy futures to capture the gap — but it can still incur a loss.

Should We Implement This Independently or Buy an Arbitrage Fund?

Implementing this independently requires research and upfront capital. As discussed in the example above, a single stock trade needs around ₹5.5 lakh in total. Transaction costs are also higher when selling futures, and under government rules, independent arbitrage activity falls under F&O — profits are taxed at up to 30%. Short-term capital gains tax also applies if the position is exited within a year.

In an arbitrage fund, all costs are already factored into the return. If an investor holds for more than a year and exits, the gains are treated as long-term capital gains and taxed at 12.5% in India.

Why an Arbitrage Fund Mostly Makes Money

The reason is straightforward: the fund always hedges cash positions with futures. In low-volatility markets, the spread is thin and returns drop to liquid fund levels. Costs such as STT, brokerage, exchange fees, and expense ratios also eat into returns. In high-volatility markets, the spread widens and the fund can generate a higher return.

You can compare an arbitrage fund against a fixed deposit after tax at your own slab with our arbitrage fund vs FD calculator, which also shows the FD rate you would need to match the fund.

Top Arbitrage Funds by Returns and Ratings

Here are the top arbitrage funds with their returns, sorted by 1-year return as of August 2026.

Returns up to 1 year are on an absolute basis and more than 1 year are on a CAGR basis. Ratings are Morningstar/Fincash star ratings. Data as of August 11, 2026.

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References

1. SEBI — Categorization and Rationalization of Mutual Fund Schemes (Oct 2017)
2. AMFI India — Mutual Fund NAV and Returns
3. Value Research — Arbitrage Fund Category
4. NSE India — F&O Quotes and Market Data
5. Income Tax Department, India — Capital Gains Tax

Returns and fund data are approximate as of August 2026 and are subject to change. Verify with the respective fund house or AMFI before investing.

This analysis is for educational purposes only and does not constitute investment advice. Please consult a SEBI-registered investment adviser before making any investment decision.