by Reverse Cash and Carry arbitrage is a combination of short position in underlying asset (cash) and long position in underlying future. It is initiated when future is trading at a discount as compared to cash market price. In other words, the cash market price is trading higher as compared to future. The arbitrageur/ trader can take position by selling his delivery of stocks in cash and simultaneously buying futures of same underlying assets of equal quantity. A trader must have delivery in that particular stock when there is such an opportunity available in the market.
Reverse cash and carry arbitrage occurs when market is in “Backwardation”, which means future contracts are trading at a discount to the spot price.
Reverse cash and carry arbitrage is performed when the futures is trading at a discount to the cash market price.
Lets assume the following data:
Cash market price: Rs.100
December futures price: Rs.90
This reflects a negative cost of carry which is bound to reverse to positive at some point in time during contract’s life and this reversal is an opportunity for traders to execute reverse cash and carry arbitrage.
Lets assume a contract multiplier for futures contract on Stock A is 200 shares. To execute reverse cash and carry, arbitrageur will buy one Dec Fut at Rs.90 and sell 200 shares of Stock A at Rs.100 in cash market. This would result in the arbitrage profit of Rs. 2000 (200 X Rs.10). Position of the arbitrager in various scenarios of stock price would be as follows:
Case I: Stock rises to Rs. 110
Loss on underlying = (110 – 100) x 200 = Rs. 2000
Profit on futures = (110 – 90) x 200 = Rs. 4000
Net gain out of arbitrage = Rs. 2000
Case II: Stock falls to Rs. 85
Profit on underlying = (100 – 85) x 200 = Rs. 3000
Loss on futures = (90 – 85) x 200 = Rs. 1000
Net gain out of arbitrage = Rs. 2000
On maturity, when the futures price converges with the spot price of underlying, the arbitrageur is in a position to buy the stock back at the closing price/ settlement price of the day.
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