Definition
Index Arbitrage
Index arbitrage exploits price differences between an index's futures and the basket of its underlying stocks (or an ETF), buying the cheaper and selling the dearer to capture the convergence.
Indian arbitrageurs trade the gap between Nifty futures and a replicating basket of the 50 constituents, or between an index ETF and its underlyings. When futures trade rich to fair value (cost-of-carry), they sell futures and buy the basket; when cheap, they reverse, locking in the spread as it converges by expiry.
Index arbitrage links the cash, futures and ETF markets, keeping their prices coherent, and is closely related to the ETF creation/redemption arbitrage that authorised participants run. It also drives concentrated flows around expiry and index rebalancing, which other traders try to anticipate.
Related terms
- Basket TradingBasket trading is the buying or selling of a predefined group of securities together in proportions that match a target portfolio, index, or hedge, executed as one logical order.
- ETF Creation/RedemptionCreation and redemption is the primary-market mechanism by which authorised participants exchange a basket of underlying securities (or cash) for new ETF units, or hand back units for the basket, keeping the ETF price aligned with its NAV.
- Index Inclusion ImpactIndex inclusion impact is the price and volume effect on a stock when it is added to or removed from a widely tracked index, driven by forced trading from passive and benchmarked funds.
- Cash-Futures ArbitrageCash-futures arbitrage profits from the gap between a stock's cash price and its futures price relative to fair value, capturing the cost-of-carry by holding the cash position against an offsetting futures position.
Plain-English explainer from The Dispatch Investors Encyclopedia. General information, not financial advice.