fbpx

A gentle introduction to Cash and Carry Arbitrage

Cash and Carry Arbitrage

Cash and Carry Arbitrage is an arbitrage strategy that is market neutral. Meaning it is a strategy designed to bring profit for the arbitrageur in the event of increasing or decreasing prices for one or more markets while attempting to curtail or avoid some specific risks in those markets.

Using Cash and Carry strategy is usually borne of existing divergence between the market price of a stock or security and the fundamental value.  But, fundamentally, it is an act of matching long and short positions in securities to increase one’s profit from making good stock selections and decreasing the return from broad market movements.

In other words, a trader uses this strategy to exploit market pricing discrepancies between the asset and the derivative to their advantage via a correction in the mispricing. The system is at times also called basis trading.

The strategy combines the purchase of a long position of an asset while simultaneously carrying out the sale (short) of a position in a futures contract on that same underlying asset to make riskless profits.

Advertisements
Advertisements

To have this strategy generate riskless profit, futures contracts on the asset must be theoretically more expensive relative to the underlying asset.

It should be made clear at the outset that Cash-and-carry arbitrage cannot be considered entirely risk-free since it is based on carrying a futures contract.  Certain costs may go up, like the brokerage house’s margin rates. The riskless profits mentioned here are in consideration of any market movement, which is generally considered a greater risk.  In cash and carry arbitrage, such risk is mitigated because once the trade is executed, the only event that needs to be carried out is the delivery of the asset against the futures contract.

Interesting for you:  Machine Learning in Trading: Review of Q-Learning

Another risk that cash-and-carry arbitrage carries is whether the futures contract partner fulfills their obligation. However, if a futures sale is on a futures exchange, this risk does not apply. In addition, the arbitrageur may be required to pay collateral to the futures exchange, which may expose him to specific liquidity risk.

To consider an example, suppose you had purchased an asset that is currently trading at $103 in the market on spot purchase, with a total associated carrying cost of $2. Fortunately for that same asset, there exists a futures contract valued at $110. Now, as an investor, you identify this arbitrage opportunity in the market and wish to invest in it, intending to earn a profit out of the deal using the cash and carry strategy.

Advertisements
Advertisements

You, as an investor, purchase the underlying asset at $103 and take a long position. At the same time, you also short the futures contract on the underlying asset at $110 and sell it off. When you short the futures contract, you have effectively locked in a sale at $110 by holding the underlying contract until the delivery date (i.e., expiration date) of the futures contract and then delivering it on the date against the futures contract.

In the above example, your underlying asset cost is $105 (which is the cost it was priced on spot purchase plus its carrying cost), but you also locked its sale at $110 by shorting the futures. You, hence arbitrage a profit of $5 by being clever and exploiting the mispricing between the spot price and the futures contract to your advantage.

Interesting for you:  What is Quantamental? and why is it important in state-of-the-art Quantitative Trading?

To exploit the risk-free return, the arbitrageur/ trader will have to hold the asset until the expiration/maturity date of the futures contract arrives. Therefore, the above strategy would be profitable only if the cash flow from the future at expiration exceeds the acquisition cost and carrying cost on a long asset position.

Defining terms for a Cash-and-carry arbitrage in more specific terminology of the trade is a case of Contango and Backwardation.

A market is said to be in Contango when the future price of a security is higher than the spot price of the said security. Therefore, it is when the market is in Contango that cash-and-carry arbitrage opportunity occurs. 

The term contango is primarily used in the commodities market where we are talking about tangible assets, while the term premium is used in the equity and derivatives markets. 

Advertisements

Backwardation is said to have happened when the above scenario has reversed itself, and that’s when reverse cash and carry arbitrage is said to have occurred. Backwardation, which is a commodity term, is also called discount in the equity and derivatives markets. 

Therefore, when the premium widens, it is a sign of a bullish market.  Alternatively, when the discount widens, it points to a bearish market.

Reverse cash-and-carry arbitrage is the exact opposite of the cash-and-carry arbitrage strategy. The trader combines a short position in a security and a long futures position in that same security. The idea here is also to exploit pricing inefficiencies between that security’s spot price and the corresponding future price to generate riskless profits.

When the security matures, the asset gets delivered against the futures contract, which is then used to cover the short position taken earlier. In reversing strategy, a lower futures price than the spot price of the asset makes it profitable. The plan renders the proceeds from the short sale that exceed the price of the futures contract and the costs incurred with carrying the short position in the asset.

Interesting for you:  What is Nowcasting? Why should you know it?

In conclusion, a Cash-and Carry arbitrage, as well as the reverse cash-and-carry arbitrage strategies, allow an astute trader to exploit mispriced assets and make a handsome profit that is virtually riskless.

Leave a Reply

%d bloggers like this: