What is Reverse Cash and Carry Arbitrage?
Reverse cash and carry arbitrage are not very common. To that extent, it is unlike the traditional straight arbitrage. Reverse cash and carry arbitrage happens when the futures are at a discount to the spot price and are attractive even after you consider the cost of carrying. In this segment, we look at the various profit-making opportunities in reverse cash and carry arbitrage. We also look at how to apply and use the reverse cash and carry arbitrage strategy in practice.
Reverse Cash and Carry Arbitrage
What exactly do we understand by Reverse cash and carry arbitrage? You can understand reverse cash and carry arbitrage as the inverse of the traditional straight cash and carry arbitrage commodity trading strategy. Like cash and carry arbitrage, even Reverse cash and carry arbitrage is a market-neutral strategy. The idea is to take advantage of mispricing, the only difference is that in the case of Reverse cash and carries arbitrage, the futures price is not at a premium to the spot price but a discount to the spot price. It also seeks to exploit the market inefficiencies between the spot price and future price.
In the reverse cash and carry arbitrage strategy, the trader takes a short or sells position in the spot price of a commodity and a long position on its future price. How do you short a commodity? You can either borrow the commodity and sell it or you can sell the commodity or stock that is owned in your Demat account or the commodity that is available at your warehouse. It is different from being short in equities. In commodities trading, the trader must consider the storage and carry cost when calculating the value in a commodity’s future price and deciding if the strategy is worthwhile. In commodities, the cost of carrying is not just interest cost but also storage, transport, and insurance.
Reverse cash and carry is the inverse of cash and carry
Reverse cash and carry arbitrage is the inverse of cash and carry arbitrage. It is also a market-neutral strategy because it only seeks to take advantage of market inefficiencies between a commodity’s spot price and its future price. The only difference is that in reverse arbitrage we are not looking at contango but we are up against backwardation or discount on futures over the spot. Utilizing the reverse cash and carry arbitrage trading style to take advantage of mismatches in the market is not without inherent risks because carrying costs may fluctuate within a one-year carry period and that can change the economics of the arbitrage transaction.
Backwardation and reverse cash and carry arbitrage
A normal market where commodity futures prices are higher than spot commodity prices is called a contango market. In a contango market, there is an upward sloping futures curve. In a market where there is a downward sloping futures curve, futures pricing is called backwardation. It is a market with backwardation that is ideal for reverse cash and carry arbitrage. Traders who are sitting on inventory can use this strategy to make profits out of idle commodities by exploiting the discount. However, backwardation is not very common in futures since there is also storage and carry costs, especially for commodities. Normally, backwardation is an anomaly that appears temporarily due to market volatility and also vanishes equally quickly.
Example of Reverse Cash and Carry Arbitrage
Let us take a commodity X where the spot price is Rs.204 per contract and the one-year forward price is Rs.198. In addition, you estimate that the cost of carrying is Rs.3 per annum on the contract. If you do reverse arbitrage by selling the spot and buying the futures, then there is an assured arbitrage profit of Rs.6 (204-1980. However, this would be offset partially by the Rs.3 cost of carrying so the effective spread over the cost of carrying in the reverse arbitrage strategy would be Rs.3 (6-3).
To do a reverse arbitrage, you must either own the commodity or stock or you must have the capacity to borrow and hold for the required period. Many large institutions help their large institutional clients do such trades which can be quite lucrative for short periods.
What influences the cost of carrying?
To understand if mispricing is occurring, one must know all additional costs over and above the spot price that goes into the cost of carrying. Here are a few samplers.
- Transportation costs: How much does it cost to move the commodity from the origin to the destination like the warehouse etc.
- Storage costs: How much does it cost to store the commodity from the time it is purchased to when it is to be transported? Consider all costs end to end.
- Financing: What is the cost of borrowing the capital needed to leverage large commodity trades or the cost of borrowing commodities/stocks.
- Insurance: Is insurance required and what is the implied cost of insurance.
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
Cash and Carry Vs Reverse Cash and Carry
In a cash and carry arbitrage transaction, the trader buys the spot position and sells the futures position. The necessary condition is that the futures are more than the expected spot price. In other words, the futures price is more than the spot price plus the cost of carrying. In the case of reverse cash and carry, it is normally done when the futures are at a substantial discount to the spot. In such cases, you sell existing delivery and buy the futures when futures are at a discount with the idea of reversing and making a risk-less profit on expiry.
Frequently Asked Questions Expand All
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.
You can just understand the reverse cash and carry as the opposite of a normal cash and carry arbitrage. The reverse cash and carry is done only when the futures is at a discount due to mispricing.