All About Cash and Carry Arbitrage

Arbitrage is an important aspect of trading. Arbitrage is when you buy or sell an asset to take advantage of differences in the market's pricing. Because of its simplicity, arbitrage is one of the most well-known trading strategies. Arbitrage trading strategy is cash and carry arbitrage.

Cash and carry arbitrage is the term that describes how a trader uses the price difference between an asset or its derivative in another marketplace to gain profit. Cash & Carry arbitrage refers to an asset that is in cash markets and its derivative that will be in the future.

How does the carry arbitrage definition work?

Cash & Carry arbitrage is when an asset's future price is higher than its current cash market. The trader would take a long position in the spot or cash markets and open a short position in the futures contract for the same asset. Because the asset is held until the expiration date of the future arrives, the term 'carry' was used. Basis is the name for the price difference.

Futures contract and arbitrage opportunity

Cash carry arbitrage requires an understanding of the process involved in derivatives/futures trading. A futures contract is built on an underlying asset or spot. Although the spot and futures contracts have the same pricing at the expiration date, they are priced differently during the period leading to expiration. A trader might want to short the futures and be long the cash market if the future price is greater than the spot or the asset. This is where cash and carry arbitrage takes place.

The reverse cash & carry arbitrage is when the flip occurs, which is when a trade buys an underlying asset and then sells it short. Pricing differences can occur due to a variety reasons, including regulatory restrictions on some exchanges and demand-supply issues.

Speculation is allowed in the futures market. The further away a contract is from expiration, the greater the opportunity for arbitrage.

Cost to carry

This term is used frequently in cash and carry, reverse cash and carry arbitrages. CoC, or cost of carry, is the cost an investor or trader must bear to hold a position on the underlying market until the expiration date for the future contract. Cost of carry is usually expressed in percentages.

Contango, backwardation

• A market is considered to be in contango if the future price of an asset is higher than its spot price. Cash and carry arbitrage happens when the market is not in contango.
• - Contango is most commonly used in commodities markets, while premium is used for equity derivatives markets.
• - Reverse cash and carry arbitrage are two ways to achieve backwardation. In the equity derivatives market, backwardation can also be called discount.
• If the premium is higher than the discount, that may indicate a bullish market.

Example for cash and carry arbitrage

Let's say that an underlying asset trades at Rs.102 with a cash or carry value of Rs 3. The futures contract is priced at Rs 109. The trader purchases the underlying, and then goes long as well as shorting the future. He sells it at Rs.109. The underlying cost is Rs 105 (cost-of-carry included), but the price that the trader has secured is Rs 109. The price difference between the securities on the two markets has resulted in a profit of Rs 4.

In a nutshell

Cash & Carry arbitrage is when the future asset's price exceeds the spot or cash market price. An investor may shorten the future or take a long position on the cash market in such an instance. Before you move on to arbitrage strategies, it is important to have a good understanding of futures contracts.

Arbitrage strategies help traders benefit in a risk-free manner. You can practice the cash and carry arbitrage definition and gain a better understanding of the arbitrage strategy.