WHAT IS CASH AND CARRY ARBITRAGE

Before we get into cash and carry arbitrage, let us for a moment dwell on plain cash futures arbitrage. In a cash-futures arbitrage, you buy in the cash market and sell in the futures market. Intuitively, if the returns on the arbitrage are attractive, you go ahead and take a position in the cash-futures arbitrage. Now, cash and carry arbitrage goes one step ahead.

It is built on the premise of cash-futures arbitrage, but in reality, the cash and carry arbitrage also considers the cost of funds and other costs that impact the futures price vis-à-vis the spot price. In other words, the cash and carry arbitrage model also factors the cost of carrying into the arbitrage model. We will later understand in detail why this cash carry arbitrage approach to understanding arbitrage is so important.

CASH AND CARRY ARBITRAGE

Let us first understand, what exactly is meant by Cash and Carry Arbitrage? Cash and carry arbitrage is a financial arbitrage strategy that involves making the best of the anomalies in pricing or mispricing as it is called. This is the relation between an underlying asset and the financial derivative corresponding to it. Using the cash and carry arbitrage strategy, the trader gets a picture of the ideal cost of carrying for the contract, and based on the futures he can take a quick decision on whether or not the cash and carry arbitrage strategy would be profitable and meaningful. The cash and carry arbitrage trader uses this opportunity to generate profits via a correction in the mispricing or mean reversion as we know it.

Understanding the structure of Cash and 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 or the corresponding futures. Traders secure a profit by taking a long position on the financial commodity and selling the corresponding futures contract. Now here is where the cash and carry arbitrage model is a slight advantage over traditional cash-futures arbitrage.

Since the cost of carrying is factored into the pricing of futures to determine under-pricing, the trader effectively assumes that the long cash position is funded by borrowing while the short futures position is taken by pledging the cash position as collateral. Here is how the cash and carry arbitrage strategy would work in practice.

A trader implements cash and carries arbitrage strategy only after identifying a very lucrative arbitrage opportunity i.e. when the futures are at a serious premium to the expected spot price which is the spot price plus the cost of carrying. So, in the case of equity futures, only the interest cost is considered since the contract is cash-settled. However, in the case of cash and carry arbitrage on commodities where delivery is permissible, the actual cost of carrying would also include costs like insurance, storage, demurrage, etc, apart from the interest cost or the opportunity cost of funds.

Here is how the cash and carry arbitrage would operate in the case of commodities. For example, the commodity purchased is held until the expiration date or the delivery date of the corresponding contract. At that point, the trader 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 cost of carrying, which would include insurance, transport, storage, and notional opportunity cost.

By selling the corresponding futures contract, the investor locks in a sale at the price at which the contract is valued. Hence, the investor has effectively determined the sale price and locked in a spread. Now irrespective of whether the actual price of the stock or commodity on the date of expiration is up or down, the arbitrageur in the cash and carry arbitrage transaction still realizes his assured arbitrage profit after considering the cost of carrying.

Live example of cash and carry arbitrage

Let us take an instance where the underlying asset trades at Rs.101 in the market, with a total of Rs.3 worth of carrying costs associated with it. Fortunately for the trader, there is a futures contract priced at Rs.108. Here is what the actual cash and carry arbitrage transaction would look like.

The investor purchases the commodity at Rs.101, an effective long position. The arbitrageur also simultaneously sells the futures contract at $108. By selling the futures contract, the investor has effectively locked in the sale price of Rs.108. The investor will hold the underlying until the delivery date of the futures and then delivers it on the date against the futures contract and pocket the arbitrage profit. Here is what profits would look like.

Since there is a cost of carrying of Rs.3 on the transaction, his effective cost is Rs.104 (the cost price plus cost of carrying). However, we know that due to selling the futures, the sale price is already locked in at Rs.108, and hence there is no uncertainty here at all. The investor makes the best of this cash and carry arbitrage and realizes a profit of Rs.4 (108-104) by exploiting the mispricing to his advantage.

The only risk in cash and carry arbitrage is that cost of carrying can be fluid at times.

REVERSE CASH AND CARRY ARBITRAGE

Reverse cash-and-carry arbitrage is a market-neutral strategy combining a short position in an asset and a long futures position in that same asset. You can look at this strategy as the exact opposite of the traditional cash and carry arbitrage. The goal of this reverse cash and carry arbitrage is to exploit pricing inefficiencies between that asset’s cash, or spot, price, and the corresponding future’s price to generate riskless profits. Normally, the reverse cash and carry arbitrage is done by traders who are owning the shares in their portfolio and when the cash-futures spread becomes negative, you indulge in reverse arbitrage. These are not common and arise infrequently.

COST OF CARRYING

The cost of carrying summarizes the relationship between the futures price and the spot price. In others words, the spot price plus the cost carry is the expected spot price. It is the cost of carrying or holding a position from the date of entering into the transaction up to the date of maturity. It measures the storage cost plus interest that is paid to finance the asset less the income earned on the asset.

Frequently Asked Questions

How do you calculate cash and carry arbitrage?

Assume the following data for your own understanding. Assume that the spot price is Rs.1500 and the price of the monthly futures to be sold is Rs.1520. If you assume an annualized implied cost of carry of 8%, then the fair price measured as the expected spot price at the time of futures expiration would be Rs.1505.70. Here the effective profit after considering cost of carry is Rs.15.30 and this has to be multiplied by the lot size to get the actual profit earned per lot from the cash and carry arbitrage. Remember that this is the assured profit for the cash and carry arbitrageur irrespective of whether the price of the commodity in the market shoots up or falls sharply.

What is cash and carry trade?

A cash-and-carry trade is a trading strategy that an investor can utilize in order to take advantage of market pricing discrepancies. It usually entails taking a long position in a security or commodity while simultaneously selling the associated futures contract. IT is normally done when the futures is more than the expected spot price as per the cost of carry model.

What is cash future arbitrage?

Cash futures arbitrage is all about Buying in cash and selling in futures. This is normally undertaken when the futures is at a substantial premium to the spot price.