EN
Cash-and-carry arbitrage is a market-neutral trading strategy that exploits price differences between the spot (cash) market and the futures market for the same asset. Traders use this trading method when the futures price is greater than the spot price plus carrying costs, thereby profiting by buying the underlying asset and selling the futures contract.
Key Takeaways
-
When the futures price exceeds the spot price plus carry charges, cash-and-carry arbitrage profits are locked in.
-
Traders purchase an asset on the spot market and sell the futures contract at the same time.
-
The technique is based on contango, a market condition where futures trade above spot prices.
-
Changes in carry costs, basis risk, and market circumstances all pose risks.
What is Cash-and-Carry-Arbitrage
Cash-and-carry arbitrage is a market-neutral method in which a trader buys an asset in the spot market while selling a futures contract on the same asset to benefit from price differences. The term ‘carry’ is used because the trader carries (holds) the asset for delivery until the futures expiration date arrives.
The strategy is effective when the futures price is sufficiently higher than the spot price, after accounting for all carrying costs, such as financing, storage, and insurance. On expiry, the trader delivers the asset against the futures contract, retaining the spread as profit.
Arbitrage in Commodities
In commodities, cash-and-carry arbitrage is popular because futures prices frequently trade above spot prices due to contango. This is a situation in which futures prices exceed current spot prices due to holding and financing costs. Traders purchase physical commodities, incur carrying costs, and then sell futures to collect the difference, assuming the spread covers these charges.
Cash-and-Carry: Step-by-Step Mechanism
To fully comprehend how cash-and-carry arbitrage works in real markets, it is helpful to break down the process into several parts. The approach entails taking positions in both the spot and futures markets simultaneously, then holding the underlying asset until the futures expire. Here's how the mechanism operates in practice:
-
Identify a pricing gap: First, determine whether the futures price exceeds the spot price plus carrying costs. If so, a cash-and-carry arbitrage opportunity emerges.
-
Buy in the spot market: Buy the asset in the cash (spot) market at its current price.
-
Sell the futures contract: Simultaneously, sell (short) a futures contract for the same asset at a higher price.
-
Hold till expiration: Keep the asset until the futures contract expires and pay any associated charges, such as storage, interest, or insurance.
-
Deliver and settle: At expiration, deliver the asset and settle the futures position. Since both deals were already locked in, the profit is the difference between the futures price and the entire cost of holding the item.
The Math Behind a Cash-and-Carry Strategy
The profit in a cash-and-carry arbitrage is determined by the difference between the futures and spot prices after deducting all carrying charges. Carrying costs include finance, storage, and insurance (mostly for commodities).
The simplified formula is:
Profit = Futures price − Spot price − Carrying costs
Let’s understand with an example:
Suppose,
-
Spot price of a commodity is ₹5,000
-
Futures price is ₹5,500
-
₹100 as carrying costs
Then the arbitrage profit is: ₹5,500 − ₹5,000 − ₹100 = ₹400
This profit is realised when the futures contract expires.
Risks and Limitations
Although cash-and-carry arbitrage is sometimes referred to as a low-risk strategy, it is not entirely risk-free in real markets. Certain risks and limitations include:
-
Basis Risk: The profit from cash-and-carry arbitrage is determined by the gap between spot and futures prices (the basis). If a trader is forced to exit the position before expiration, a narrowing or widening basis can result in losses. However, if held strictly to expiration, this risk is negated as prices converge.
-
Execution Risk: Arbitrage involves buying and selling in spot and futures markets at nearly the same time. Any delay, price slippage, or incomplete order execution might diminish the anticipated spread and influence the outcome.
-
Liquidity Risk: The spot and futures markets must have sufficient trading volume. Low liquidity can result in wide bid-ask spreads, difficulties entering or exiting positions, and higher total transaction costs.
-
Carrying Cost Risk: The strategy implies predictable expenses such as finance, storage (for commodities), insurance, and taxes. Changes in interest rates or higher-than-expected carrying costs might wipe out the pricing advantage.
-
Regulatory and margin requirements: Futures holdings involve margin deposits and may result in margin calls if prices move unfavourably. Regulatory changes to contract specifications, position restrictions, or taxation can all affect strategy implementation.
-
Operational and settlement risks: Order placement errors, settlement delays, and system breakdowns can all disrupt a strategy, particularly for traders who rely on manual execution or have minimal cash.
Also Read: Futures Pricing Formula
So, how does the cash and carry arbitrage definition play out?
Cash-and-carry arbitrage occurs when the future price of an asset is higher than its current cash-market price. In such a scenario, the trader takes a long position in the spot or cash market on the underlying asset and opens a short position in the futures contract for the same asset. The reason the word ‘carry’ is used is that the asset is carried for delivery till the expiration date for the future arrives. The price difference is called the basis.
Futures contract and arbitrage opportunity
Futures are derivatives that depend on an underlying asset, and their values converge with spot prices upon expiration. When futures prices exceed spot prices, traders sell futures and purchase spot to close the price gap until convergence. Arbitrage is unprofitable if the futures price is not much higher than the spot price after carrying expenses.
Cost of carry
This term is often used 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, the cost of carry is expressed as a percentage.
Contango and Backwardation
-
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 signal a bearish market.
Also Read: What is Equity Derivatives
Example of cash and carry arbitrage
Assume that an underlying asset is trading at ₹102, with a cash or carry of ₹3. The futures contract is at ₹109. The trader buys the underlying and goes long while also shorting the future and selling it at ₹109. The underlying is priced at ₹105 (cost of carry included), but the trader has a locked sale at ₹109. Hence, the profit is ₹4, and that has happened by making use of the pricing difference between the securities in the two markets.
Conclusion
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 the cash and carry arbitrage definition helps you practice it and get a better grip on the arbitrage strategy.
Learn Free Stock Market Course Online at Smart Money with Angel One.
Also Read: How Arbitrage Trading Works?
|
Explore the Share Market Prices Today |
|
