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Arbitrage Funds Risk: Why Cash Settlement Exposes Funds to Liquidity Risk

Posted on 09 Nov 2025
Contact Muthu Kannan (aka Manki) @mkannan

Tags: Mutual Funds

7 mins read
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This article explains how cash settlement of futures contracts introduces liquidity and market risk, demanding high-quality, liquid equity portfolios in arbitrage funds.

Arbitrage Funds Risk: Why Cash Settlement Exposes Funds to Liquidity Risk

This article is a Guest Post from one of Arthgyaan’s earliest readers who is a fellow personal finance enthusiast.

About the author: Muthu Kannan, also known as Manki, is a software engineer by profession. He is intrigued by all sorts of things in life. One of them happens to be personal finance and investing.

In the personal finance space, his passions include teaching others (which is just a fancy name for learning by answering other people’s questions), building tools (mostly spreadsheets as of now), and writing about his revelations occasionally.

Readers of Arthgyaan may be interested in his blog posts about personal finance. Links to his other work and social media handles are on his home page manki.in.

Now over to Muthu Kannan (aka Manki).

📚 Table of Contents

Arbitrage funds need to be mindful of equity risks too
Future settlement in cash
Risks introduced by cash settlement
Conclusion

Arbitrage funds need to be mindful of equity risks too

I have observed a theme in financial markets: nothing is as straightforward as it initially looks. When I did my research for the article how arbitrage funds work, I had concluded that the profits were guaranteed as soon as equity shares are bought and future contracts sold. Boy, was I wrong!

My understanding of future contracts was that arbitrage funds would sell future contracts that guarantee a sale price, a sale date in future, and a purchaser who is legally bound to buy. This would be correct if the future contract were settled through physical delivery of shares. Turns out, most future contracts are settled in cash!

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Future settlement in cash

Settlement through physical delivery is easy to understand: shares move out from the arbitrage fund’s demat account and cash rolls into the fund’s bank account. But this is of little use since virtually all future contracts are settled in cash.

Let’s say an arbitrage fund establishes an arbitrage position by making two simultaneous transactions:

Buys equity shares from the cash market for ₹100 a piece.
Sells future contracts for ₹103 per share.

The guaranteed profit from this position (excluding fees) is ₹3 per share. This profit, in theory, can be realised irrespective of the share’s price movements in the cash market. Let’s look closely at the three possible scenarios.

This is the simplest case, though a fairly unlikely scenario, that the cash market price at the time of settlement (i.e., the settlement price) is exactly the same as the future contract price.

Settling the future contract: Since the contract price is the same as the settlement price, the fund neither has an obligation to send cash nor does it receive any cash.
Closing the cash position: The fund sells its share holdings at ₹103 per share.
Profit calculation: The profit earned on the cash market (₹103 - ₹100 = ₹3 per share) is the net profit.

Let’s say the share sells at ₹105 at the time of settlement. ₹105 is considered the settlement price.

Settling the future contract: The arbitrage fund has agreed to sell the shares at ₹103 a piece. Since this price is below the settlement price, cash settlement requires the fund to pay the difference, ₹105 - ₹103 = ₹2 per share. The fund sends this cash over.
Closing the cash position: The fund sells its share holdings at ₹105 per share.
Profit calculation: There is a profit of ₹5 per share in the cash market since the shares were bought at ₹100 and sold at ₹105. But the fund had to send ₹2 cash per share, which leads to a net profit of ₹3 per share.

Let’s say the share sells at ₹102 at the time of settlement. ₹102 is considered the settlement price.

Settling the future contract: The future contract’s counterparties have agreed to buy the shares at ₹103 a piece. Since the agreed price is more than the settlement price, the fund receives the difference (₹103 - ₹102 = ₹1 per share) from the counterparties.
Closing the cash position: The fund sells its share holdings at ₹102 per share.
Profit calculation: There is a profit of ₹2 per share in the cash market since the shares were bought at ₹100 and sold at ₹102. The fund has also received ₹1 per share from the counterparties. Altogether, the net profit is ₹3 per share.

If both parties to a future contract only want the cash profit from the future contract, and don’t want to hold the underlying shares, sending cash over is quicker and more efficient. Those who want to hold the shares usually buy them from the cash market; they don’t need to dabble with futures. Hence, virtually all future contracts are settled in cash.

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Risks introduced by cash settlement

The cash settlement model requires that the entity holding the shares-arbitrage funds, in our case, be able to liquidate its positions at or very close to the settlement price. This makes the fund vulnerable to liquidity risk. If trading volume for the shares is low or if the price in the cash market price falls much below the settlement price, the arbitrage fund ends up losing money.

What does this mean?

The “fully hedged equity” held by arbitrage funds can still cause a capital loss if the price in the cash market falls badly before the fund can liquidate its share holdings.
If the trading volume thins out for the shares in the cash market, arbitrage funds will either have to sell the shares at a loss or hold the shares and expose themselves to market risk until trading volume increases.
You want your arbitrage fund to spread its equity exposure across many quality, highly liquid shares whose prices won’t fall precipitously and will have enough trading volume to exit its equity positions efficiently.

Conclusion

Don’t be deceived by the phrase “fully hedged”! Arbitrage funds are mostly shielded from equity price movements, but they still need to hold a high-quality, highly liquid equity portfolio with less concentration.

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