With cash-futures arbitrage, you make a purchase in the cash or spot market and sell in the futures market. If the gains are profitable, a position is taken on cash-futures arbitrage. In cash-and-carry arbitrage, things advance further. Structured on the framework of cash-futures arbitrage, cash-and-carry arbitrage also takes the cost of funds and other types of expenses into account, which influences futures prices with respect to the spot price. Simply put, cash-and-carry arbitrage also considers the expense of carrying into the arbitrage.
In this article, we will understand the meaning and workings of cash-and-carry arbitrage in detail.
Additional read: Asset financing
Cash-and-carry arbitrage — Meaning
A market-neutral manoeuver, cash-and-carry arbitrage combines the buying of a position for securities like stocks or commodities and the selling (short) of a position in the future contract of the same underlying security. By doing so, it wishes to harness the pricing inefficacies for assets in the spot or cash market and futures market to generate riskless gains. Theoretically, the futures contract must be relatively expensive compared to the underlying asset, or else the arbitrage would not make profits.
Additional read: Asset turnover ratio
Understanding the basics of cash-and-carry arbitrage
In a cash-and-carry arbitrage model, an arbitrageur usually seeks to retain or ‘carry’ the asset till the date of expiry of the futures contract, after which it would be delivered against the contract. Hence, this strategy only makes sense if the short futures’ cash inflow surpasses the carrying and acquisition costs on the long position of the asset.
It is important to note that a cash-and-carry arbitrage approach is not entirely riskless. There is a possibility of rising carrying costs, including brokerage increasing its margin. However, the possibility of market movements, a crucial element in every typical long or short trade, is diminished once the trade is underway. The only outcome is the asset delivery against the futures contract. There is no necessity to utilise either one on the open market upon expiration.
Physical assets, such as grains or oil, require proper storage facilities and insurance coverage, but stock indices only need financing expenses like margins. Therefore, given everything else is constant in the non-physical market, arbitrage might prove to be more lucrative. However, more market participants are allowed to try such trades as the roadblocks to take part in arbitrage are much lower. As a result, there is an enhanced pricing efficiency between futures and spot markets and lower spreads between the two. These reduced spreads mean that there is a limited window to make profits.
Arbitrage possibilities may still be present in less proactive marketplaces, provided there is sufficient liquidity in both spot and futures markets.
Additional read: Shares
Cash-and-carry arbitrage — Example
Let us use an example to understand how cash-and-carry arbitrage works in capital markets. Assume that a security is trading at Rs. 1,000 currently, while the futures contract for one month costs Rs. 1,400. Additionally, the monthly carrying costs like insurance, storage, and financing transactions round up to Rs. 300.
In this scenario, the arbitrageur would either purchase the security or open a long position at Rs. 1,000 and, at the same time, sell a futures contract of one month, i.e., take a short position at Rs. 1,400. They would then carry or hold the security till the date of expiry of the contract and deliver the security against the contract. By doing so, they will ensure a riskless profit of Rs. 100.
Reverse cash-and-carry arbitrage
A reverse cash-and-carry arbitrage, like the cash-and-carry model, is a market-neutral strategy that uses a mix of a security's short position and a long futures position of the same security. This type of arbitrage is the exact opposite of the regular cash-and-carry model arbitrage. Here, the aim is to capitalise on pricing anomalies between the security’s spot or cash price and the aligning price of the futures contract to make riskless gains. Usually, it is employed by day traders who own stock in their portfolios when the cash-futures spread turns negative. Its use, however, is uncommon.
Additional read: Share market basics
Cost of carrying - Basics
The carrying expense outlines the correlation between the spot price and the futures price. In essence, the expected spot price is the result of adding the spot price and the cost carry. It refers to the expenses incurred while maintaining positions from the transaction initiation to the maturity date. This cost encompasses storage fees and interest payments for asset financing and subtracts the income generated on the security.
Closing thoughts
The cash-and-carry arbitrage strategy is characterised by purchasing assets such as stocks or commodities and short-selling the future contract of the same underlying security to maintain a market-neutral approach. In this way, it aims to exploit the pricing anomalies in the spot or cash market and futures market to create risk-free profits. Keep in mind that the cash-and-carry arbitrage model is not without risk. Rising carrying costs, like brokerage margin hikes, could impact the outcome.
