Cash-Futures Arbitrage Detailed
Cash-futures arbitrage in Indian markets exploited the pricing relationship between the Nifty or stock spot price and the corresponding futures price, buying the underpriced leg and selling the overpriced leg when the futures premium exceeded the cost-of-carry, locking in a theoretically risk-free spread until expiry.
Under no-arbitrage pricing theory, a futures contract should trade at the spot price plus the cost of carry — the interest rate on funds tied up in the position over the remaining life of the futures contract, minus any expected dividends on the index constituents. In Indian markets, with short-term interest rates in the 6-7% range during the 2020-2023 period, Nifty futures one month out should theoretically trade approximately 0.5-0.7% above the spot index.
When the actual futures premium exceeded this fair value — a condition observable from the NSE futures data — market participants could execute a cash-futures arbitrage: buying the Nifty constituents in the cash market (or a representative ETF) and simultaneously selling an equivalent number of Nifty futures contracts. At expiry, the futures position converged to spot price (as futures settled at the final settlement price), and the arbitrageur earned the excess premium that was locked in at entry.
The execution challenges of this seemingly risk-free trade were significant in practice. Buying all 50 Nifty constituents in proportion to their index weights required substantial capital and generated transaction costs including brokerage, STT on equity delivery trades, and impact cost on each stock. For small participants, these costs frequently exceeded the excess premium, eliminating the arbitrage profit.
Arbitrage mutual funds — a category in India that grew significantly from 2015 onward — were designed specifically to exploit cash-futures arbitrage at scale. By pooling investor capital, they could execute the trades cost-efficiently and pass the returns to investors at tax rates applicable to equity funds, giving the strategy a tax advantage over pure debt alternatives for moderate holding periods.
Risks in practice included the basis risk between the actual portfolio held and the Nifty index (if using an ETF with small tracking error), the overnight margin call risk on the short futures position (requiring buffers of liquidity), and the scenario of futures discount — where futures traded below spot during extreme market stress, temporarily making the standard trade unprofitable and requiring positions to be held to expiry rather than closed early.