Index Arbitrage Strategy in Indian Markets: Cost of Carry, Costs and Tax

What Index Arbitrage Actually Means in the Indian Market

Index arbitrage is the trade of buying an index in one form and selling it in another when the two prices drift apart by more than the cost of holding the position. On the NSE the two forms are the spot index, which you replicate by buying the underlying basket of stocks or a tracking ETF, and the index futures, such as the Nifty 50 future with a lot size of 65 or the Bank Nifty future with a lot size of 30. When the future trades above its true value you sell the future and buy the basket. When the future trades below, you do the reverse.

The word that matters is basis. Basis is simply Futures price minus Spot price. A future almost always trades at a premium to spot in India because holding the basket costs money, you pay interest on the capital, and the future lets you control the same exposure with only margin. That premium is not free profit. It is the market paying you to carry the position, and it should equal the cost of carry. Arbitrage only exists when the actual basis is meaningfully larger or smaller than the fair carry.

This is a low return, capacity heavy strategy dominated by proprietary desks and institutions running it with automated execution. A retail trader reading this should treat it first as a way to understand how futures are priced, and only second as a live trade. The sections below give the exact carry formula, a fully costed Nifty example with current STT and brokerage, and the tax treatment, so you can judge for yourself whether a given spread is worth taking.

The Cost of Carry Formula, Spelled Out

The fair value of an index futures contract is the spot price grown forward at the net financing rate until expiry. The clean continuous compounding version used in textbooks is Fair Value = Spot times e raised to (r minus d) times t. Here r is the annualised risk free rate, for example 6.5 percent expressed as 0.065, d is the annualised dividend yield of the index, around 1.2 to 1.4 percent for Nifty, and t is the time to expiry expressed as a fraction of a year. For a contract 28 days from expiry, t equals 28 divided by 365, which is about 0.0767.

For day to day trading the simple interest version is close enough and easier to reason about: Fair Value = Spot times (1 plus (r minus d) times t). The quantity Spot times (r minus d) times t is the rupee cost of carry. If that works out to, say, 30 points on Nifty, then the fair futures premium is 30 points. If the future trades 70 points over spot, there are roughly 40 points of excess premium to chase, before costs. If it trades only 5 points over spot, the future is cheap and the reverse trade may be on.

• r is the funding cost, the rate at which you borrow to buy the basket. Use your actual cost, often the broker margin funding rate or an MIBOR linked rate, not just the repo rate.
• d is the dividend yield you will actually receive before expiry, not the trailing annual yield. Lumpy dividends near expiry matter far more than the headline number.
• t shrinks every day, so the fair premium decays toward zero as expiry nears. On expiry day, fair value equals spot and the basis must collapse to zero.
• The basket you buy must track the index. A rough proxy made of a few large stocks introduces tracking error that can swamp the arbitrage profit.

A Dated, Fully Costed Nifty Example

Take a concrete illustrative scenario. Assume it is 3 June 2026 and the June Nifty 50 futures expire on 25 June 2026, so there are 22 calendar days left and t equals 22 divided by 365, about 0.0603. Suppose the Nifty 50 spot is at 24,800, the risk free funding rate r is 6.75 percent, and the dividend yield expected before expiry d is 0.5 percent for this short window. These figures are illustrative, not a live quote.

The net carry rate is r minus d equals 6.75 minus 0.5, which is 6.25 percent, or 0.0625. Cost of carry in points equals 24,800 times 0.0625 times 0.0603, which is about 93.5 points. So the fair June futures value is roughly 24,800 plus 93.5, equal to about 24,893. Now suppose the June future is actually quoting 24,960. The actual basis is 24,960 minus 24,800, equal to 160 points. The fair basis is 93.5 points. The future is rich by about 66.5 points. That excess is the gross arbitrage edge.

You would sell 1 lot of June Nifty futures at 24,960 and buy a matching 24,800 worth of the Nifty basket, sized to the same notional. One Nifty future lot is 65 units, so the futures notional is 24,960 times 65, equal to Rs 16,22,400. You buy roughly the same rupee value of the Nifty basket or a Nifty ETF in the cash market. At expiry the future settles at the spot level, the basis converges to zero, and you collect close to the 66.5 point excess on 65 units, which is 66.5 times 65, about Rs 4,322 gross. The whole question is whether costs eat that Rs 4,322.

The Costs That Decide Whether the Trade Survives

This is where a generic explanation goes wrong by waving costs away. In India the costs are specific and they hit both legs. On the futures leg you pay STT of 0.05 percent on the sell side of futures, exchange transaction charges of about 0.0019 percent per side, SEBI charges, GST at 18 percent on brokerage plus transaction charges, and stamp duty of 0.002 percent on the buy side. On the cash leg, if you take delivery you pay delivery STT of 0.1 percent on both buy and sell, which is heavy, plus 0.1 percent more when you sell to unwind. Delivery cash and carry is therefore costly, which is why desks prefer ETF or near zero brokerage routes.

Let us cost the futures leg of the example. Selling 1 Nifty lot at 24,960 with notional Rs 18,72,000, STT at 0.05 percent on the sell side is about Rs 936. At expiry you square off, and STT applies again on the relevant side, adding more. Exchange charges at roughly 0.0019 percent on Rs 18,72,000 per side are about Rs 36 per side, GST at 18 percent on brokerage plus those charges adds a few rupees, stamp duty on the buy side is about Rs 37, and a discount broker flat fee is about Rs 20 per order. Across both legs and both fills the futures leg alone can run Rs 1,150 to Rs 1,450.

Now add the cash leg. If you replicate with a Nifty ETF worth about Rs 18,72,000 and exit on expiry, delivery STT at 0.1 percent on the sell side alone is roughly Rs 1,872, plus buy side charges, exchange fees, GST and stamp duty. Realistically the cash leg adds another Rs 2,000 to Rs 2,800. Total round trip costs on both legs can therefore reach Rs 2,800 to Rs 3,700 against a gross edge of Rs 4,987. The net profit shrinks to roughly Rs 1,300 to Rs 2,100, before any slippage, on Rs 18.7 lakh of deployed capital for 22 days. That is the honest picture.

Calendar Spread Arbitrage, the Cheaper Cousin

Because the cash leg is so expensive, many traders run a calendar spread instead, also called a roll arbitrage. Here you trade two futures of the same index, the near month and the far month, with no cash basket at all. The fair value gap between the two months is again pure cost of carry over the extra days. If the far month is unusually expensive relative to the near month versus its fair carry, you sell the far month and buy the near month, then unwind when the spread normalises.

The big advantage is cost. Both legs are futures, so you avoid the punishing 0.1 percent delivery STT of the cash leg, and STT on futures is only on the sell side at 0.05 percent. The margin is also far lower because the exchange recognises the offsetting position and charges a spread margin rather than two full margins. The trade off is that a calendar spread is not a locked convergence to spot. It depends on the spread between two future expiries behaving, and a sudden dividend announcement or a liquidity squeeze in the far month can move the spread against you before it reverts.

Bank Nifty and Stock Specifics

Bank Nifty behaves differently from Nifty for arbitrage because its constituents, led by HDFC Bank, ICICI Bank, SBI, Axis Bank and Kotak, carry a higher and lumpier dividend yield, and the index is more volatile. The Bank Nifty futures lot size is 30. Higher dividend yield means the net carry r minus d is smaller, so the fair premium over spot is thinner, and around bank dividend dates Bank Nifty futures can slip into a small discount. That makes the reverse arbitrage, buy future and sell basket, more common in Bank Nifty than in Nifty.

Single stock arbitrage on liquid names like Reliance, TCS, Infosys or HDFC Bank uses the same cost of carry logic but adds two extra risks. First, individual dividends are large and discrete, so misjudging an upcoming dividend can wipe the edge in one event. Second, single stock futures have wider bid ask spreads than the index future, so execution slippage is worse. For a name like Reliance, you would compute fair value the same way, Spot times (1 plus (r minus d) times t), but use that stock own expected dividend for d, not the index yield.

• Nifty lot 65, FinNifty lot 60, Bank Nifty lot 30, Sensex lot 10. Use the correct lot size when sizing the cash leg so both legs match in notional.
• Higher yield baskets like Bank Nifty have thinner futures premiums and flip to discount near dividend dates.
• For single stocks, the dividend you must subtract is that one company announced dividend before expiry, not the index average.
• Weekly index options exist, but index futures are monthly and settled in cash, so there is no physical delivery on the index future itself.

How Futures Settle and Why Convergence Is Reliable

Index futures in India are cash settled on expiry against the closing value of the underlying index, calculated as a weighted average of the last half hour of trading. There is no delivery of the basket on the index future. This is the engine that makes the arbitrage work, because on expiry day the futures settlement price is forced to equal the spot index, so any remaining basis must collapse to zero. That guaranteed convergence is what lets you treat the excess premium as capturable, provided you hold to expiry.

You do not have to hold to expiry. If the basis normalises before expiry, say the rich 66.5 point excess in our example shrinks to 10 points after a week, you can unwind both legs early and bank most of the profit while paying costs only once more. Many desks actively manage the spread rather than waiting, because capital tied up for the full month at a 6 to 7 percent funding cost is itself a drag. The decision is whether the remaining edge beats the remaining carry cost of staying in.

Taxes on Arbitrage Profits in India

This is a common trap. Profit from futures and options is treated as business income under Indian tax law, not as capital gains. It is added to your total income and taxed at your applicable slab rate, with no special concessional rate. So the favourable equity rates that apply to delivery investing, STCG at 20 percent and LTCG at 12.5 percent above Rs 1.25 lakh, do not apply to your futures leg at all.

The cash leg can be taxed two ways. If you buy and square off the same day, it is intraday or speculative business income, again at slab. If you hold the basket as delivery for the duration of the arbitrage and sell after expiry, the equity short term capital gains rules apply to that leg, currently STCG at 20 percent for holdings up to one year. Because an arbitrage usually closes within a month, you almost never reach the long term twelve month threshold, so LTCG at 12.5 percent above Rs 1.25 lakh is rarely relevant here. STT paid is a cost, and for business income treatment it is generally deductible as an expense. Always confirm your exact treatment with a tax professional, since the line between investor and trader depends on your overall activity.

• Futures leg profit: business income, taxed at slab, no concessional rate.
• Same day cash leg: speculative or non speculative business income at slab.
• Delivery cash leg held under one year and sold: equity STCG at 20 percent.
• STT and other charges are deductible expenses when you report F and O as business income, which softens the cost drag at a high slab.

Risks That Make This Not Truly Risk Free

Textbooks call arbitrage risk free, but the live version has real risks. Execution risk is the biggest. You must fill both legs at the prices you saw, and if the future moves while your basket order is still filling, your locked edge can vanish. This is why the strategy is dominated by automated systems that fire both legs together. Dividend risk is next. If a constituent declares an unexpected special dividend before expiry, your fair value assumption was wrong and the future you thought was rich was actually fair, leaving you with a loss.

There is also margin and funding risk. You post margin on the futures leg and capital on the cash leg, and if the future moves against your short before convergence you face mark to market debits and margin calls even though the trade is hedged and will converge at expiry. If you cannot fund the margin, you may be forced to close early at a loss. Finally there is liquidity and slippage risk in the cash basket, especially with single stocks, where wide spreads quietly erode the thin edge.

A Practical Checklist Before You Take the Trade

• Compute fair value with Spot times (1 plus (r minus d) times t) using your real funding rate and the dividends actually due before expiry.
• Subtract the full round trip cost stack on both legs, then require a clear cushion above break even, not a razor thin one.
• Size the cash leg to the exact futures notional using the correct lot size, 65 for Nifty, 30 for Bank Nifty, 60 for FinNifty.
• Prefer ETF or calendar spread routes to avoid the 0.1 percent delivery STT that kills cash and carry.
• Check the dividend calendar for every constituent between now and expiry before assuming d.
• Plan how you will fund margin calls during the hold, since mark to market can debit you before convergence pays you.
• Record the trade in your risk management log with entry basis, fair basis, costs and net edge so you can review whether it actually worked.

Used this way, index arbitrage is less a get rich scheme and more a discipline. It forces you to price futures correctly, respect transaction costs, and understand why a premium exists. Even if you never run it live, the cost of carry lens will make you a sharper futures and options trader, because you will instantly know whether a future is rich, cheap or fairly priced for the days to expiry.

Sources and Further Reading

For authoritative data and contract specifications refer to NSE India, NSE Indices (Nifty Indices), SEBI and Zerodha Varsity. Always confirm current STT rates, charges, lot sizes and expiry dates on the official source before you trade, since these change.

Sources and Further Reading

For authoritative data and further reading on this topic, refer to NSE India, NSE Indices (Nifty Indices), SEBI (Securities and Exchange Board of India) and Zerodha Varsity. Always confirm current rules, rates and contract specifications on the official source before you trade.