Cash & Carry Arbitrage

Cash and carry arbitrage is a financial arbitrage strategy that involves the exploitation of the mispricing between an underlying asset and the financial derivative corresponding to it. Using the cash and carry arbitrage strategy, a trader aims to use market pricing discrepancies between the underlying(s) and the derivative to their advantage by exploiting the opportunity to generate profits via a correction in the mispricing. The strategy is sometimes also referred to as basis trading.

This is a term used often in cash and carry and reverse cash and carry arbitrages. The cost of carry or CoC is the cost that a trader or investor has to bear for holding a position in the underlying market till the future contract’s expiration date arrives. Typically, cost of carry is expressed as a percentage.

Contango and backwardation

• When a market is said to be in contango when the future price is higher than the spot price of the asset. It is when the market is in contango that cash and carry arbitrage occurs.
• The term contango is largely used in the commodities market while the term premium is used in the equity derivatives market.
• Backwardation happens in an exactly reverse scenario, and that’s when reverse cash and carry arbitrage comes into play. Backwardation is also termed discount in the equity derivatives market.
• When the premium widens, it is indicative of a bullish market and when the discount widens, it may be a sign of a bearish market.

Example of cash and carry arbitrage

Assume that an underlying asset is trading at Rs 102, with a cash or carry of Rs 3. The futures contract is at Rs 109. The trader buys the underlying and goes long while also shorting the future and selling it at Rs 109. The cost of the underlying is Rs 105 (cost of carry included) but the sale that the trader has locked is at Rs 109. Hence, the profit is Rs 4, and that has happened by making use of the pricing difference between the securities in the two markets.

In a nutshell

Cash & carry arbitrage occurs when the price of an asset in a future contract is greater than the price of the underlying in the spot or cash market. In such a scenario, the investor shorts the future and takes a long position in the cash market. Getting a fair understanding of how futures contracts work is important before you take the step towards arbitrage strategies.

Arbitrage strategies help traders benefit in a risk-free manner. Understanding cash and carry arbitrage definition helps you practice it, and get a better grip on the arbitrage strategy.

How It Works

A trader implements a cash and carry arbitrage strategy by identifying lucrative arbitrage opportunities in the market. They identify and invest in securities that they identify as mispriced in relation to each other. The trader opts to go long in a commodity, while, at the same time, taking a short position for the corresponding financial derivative and selling it off.

The commodity purchased is held until the expiration date, i.e., the delivery date of the corresponding contract. The trader then delivers the underlying against the corresponding contract and locks in a riskless profit. The profit earned by the trader is determined by the purchase price of the underlying plus its total carrying cost.

By shorting the corresponding contract, the investor locks in a sale at the price at which the contract is priced at. Hence, the investor will already have determined the sale price. If the purchase price of the underlying plus its carrying cost is less than the price at which the contract is sold, the trader makes a riskless profit by exploiting this mismatch of prices.

Risks Associated with Cash and Carry Arbitrage

In the cash and carry arbitrage strategy, the acquisition cost of the underlying is certain; however, there is no certainty with regards to its carrying costs. In the event that the carrying costs of the underlying increase and rise beyond the locked-in sale price of the corresponding contract, the investor incurs a loss instead of a profit. An example of an increase in carrying costs is the rising margin rates by brokerage firms.

Summary:

• Cash and carry arbitrage is a financial arbitrage strategy that involves the exploitation of the mispricing between an underlying asset and the financial derivative corresponding to it.
• Using the cash and carry arbitrage strategy, a trader aims to use market pricing discrepancies between the underlying(s) and the derivative to their advantage by exploiting the opportunity to generate profits via a correction in the mispricing.
• Traders secure a profit by taking a long position on the financial commodity and shorting the corresponding contract.