Define Cash-and-Carry-Arbitrage

Cash-and-Carry-Arbitrage

What is Cash-and-Carry Arbitrage, and how does it work?

A market-neutral strategy combining the acquisition of a long position in an asset, such as a stock or commodity, with the sale (short) of a position in a futures contract on the same underlying asset is known as cash-and-carry arbitrage. It aims to benefit risklessly by exploiting pricing inefficiencies for the asset in the cash (or spot) and futures markets. Otherwise, the arbitrage will not be successful because the futures contract is potentially more costly than the underlying asset.

TAKEAWAYS IMPORTANT

By going long in the spot market and short in the futures contract, cash-and-carry arbitrage aims to exploit price discrepancies between spot and futures markets for an asset.

The goal is to "carry" the asset for physical delivery until the futures contract expires.

Because there may be costs associated with physically "carrying" an item until it expires, cash-and-carry arbitrage is not completely risk-free.

The Fundamentals of Cash-and-Carry Arbitration

The arbitrageur in a cash-and-carry arbitration would normally try to "carry" the asset until the futures contract's expiration date, at which point it would be delivered against the futures contract. As a result, this strategy is only viable if the cash inflow from the short futures position exceeds the long asset position's purchase and carrying costs.

Cash-and-carry arbitrage positions are not risk-free since there is always the possibility that carrying costs may rise, such as if a brokerage raises its margin rates. The risk of any market movement, which is a key component in any ordinary long or short transaction, is lessened by the fact that once the trade is set in motion, the only event that can occur is the expiration of the contract.

the asset's delivery in exchange for a futures contract At expiration, neither one needs to be accessed on the open market.

Physical assets, such as barrels of oil or tonnes of grain, necessitate storage and insurance, but stock indexes, such as the S&P 500 Index, are more likely to have just financial charges, such as margin. As a result, in these non-physical marketplaces, arbitrage may be more advantageous, all else being equal. However, because the obstacles to participating in arbitrage are substantially lower, more participants are able to try their hand at it. As a result, pricing between spot and futures markets is more efficient, and spreads between them are less. Lower spreads imply less profit potential. Less busy markets may nevertheless provide arbitrage opportunities if both sides of the game—spot and futures—have sufficient liquidity.

Arbitrage Using Cash-and-Carry

Consider the following cash-and-carry arbitrage scenario. Assume an asset is now trading at $100, and a one-month futures contract is currently trading at $104. In addition, the asset's monthly carrying expenses, which include storage, insurance, and financing, total $3.

In this scenario, the arbitrageur would purchase the asset (or start a long position in it) at $100 and sell the one-month futures contract (start a short position in it) at $104. The trader would then keep or carry the item until the futures contract's expiration date, then deliver it against the contract, resulting in a riskless profit of $1.