Arbitrage is a key aspect of trading. It is the buying or sale of a certain asset so as to benefit from the pricing difference of the asset in different markets. Arbitrage is among the oldest and most popular trading strategies because of its inherent simplicity. One of the arbitrage trading strategies is called cash and carry arbitrage.
The cash and carry arbitrage definition has it that the pricing difference between an asset and its derivative in another market is made use of by a trader to benefit. In the case of cash & carry arbitrage, an asset in the cash markets and its derivative in the future has a pricing difference.
So, how does the cash and carry arbitrage definition play out?
Cash & carry arbitrage can happen when the price of an asset in the future is higher than the current cash market. In such a scenario, the trader takes a long position on the underlying asset in the spot or cash market and opens a short position on the futures contract of the same asset. The reason the word ‘carry’ is used is because the asset is carried for delivery till the expiration date for the future arrives. The price difference is called basis.
Futures contract and arbitrage opportunity
Understanding cash carry arbitrage would involve having a comprehensive idea of how the derivatives/futures trade occurs. A futures contract is based on an underlying asset and a spot — although the spot and the futures contract have the same pricing on the expiration date of the future, they are not necessarily priced similarly during the time that leads to the expiration. When the future price is higher than the spot or the underlying asset, a trader would want to short the futures and long the cash market. This is when cash and carry arbitrage happens.
When the flip happens, ie, when a trade buys the underlying asset and sells it short, it is called the reverse cash & carry arbitrage. The pricing differences occur for a variety of reasons, including regulatory restrictions in some exchanges or demand-supply issues.
The futures market makes way for speculation, and the farther the contract is from its date of expiration, the more the opportunities for arbitrage.
Cost of carry
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.