Understanding Cash-and-Carry Arbitrage
Cash-and-carry arbitrage is a market-neutral strategy where the investor combines a long position in an asset, like stock or commodity, with a short position in a futures contract on that same asset. By leveraging price inefficiencies between the spot market and the futures market, this approach seeks to secure riskless profits. Importantly, the futures contract must be priced at a premium relative to the underlying asset for the arbitrage to be profitable.
Key Highlights
- Cash-and-carry arbitrage aims to exploit discrepancies between the spot and futures markets by taking a long position in the spot market and a short position in the futures contract.
- This strategy entails holding, or “carrying,” the asset for physical delivery until the futures contract expires.
- While relatively low-risk, there are potential associated costs, such as storage and financing, that must be accounted for in the overall strategy.
Fundamentals of Cash-and-Carry Arbitrage
In this type of arbitrage, the investor seeks to hold the acquired asset until the expiry date of the futures contract, at which point it’s delivered per the contract terms. The strategy remains profitable only if the revenue from the futures contract exceeds the costs associated with acquiring and holding the asset.
Cash-and-carry arbitrage involves some level of risk. Factors such as potential increases in carrying costs (like higher margin rates) add layers of unpredictability. However, unlike conventional long or short trades, this strategy is minimally affected by market fluctuation risks due to the planned delivery against the futures contract rather than needing to engage with the open market.
Physical assets (e.g., oil barrels, grains) incur storage and insurance costs, whereas stock indexes (like the S&P 500) typically only incur financing costs such as margin interest. Because non-physical markets often have fewer participation barriers, they offer more players the opportunity to attempt arbitrage, leading to tighter pricing gaps and fewer profit opportunities.
Yet, efficient pricing between spot and futures markets reduces spreads, diminishing opportunities to profit. Meanwhile, less active markets might present viable arbitrage opportunities, provided ample liquidity exists on both the spot and futures markets.
Illustrative Example of Cash-and-Carry Arbitrage
Consider an asset trading at $100 with a one-month futures contract priced at $104. Suppose monthly carrying costs, including storage, insurance, and financing costs, amount to $3.
In this scenario, the arbitrageur purchases the asset at $100 (opening a long position) and simultaneously sells the one-month futures contract at $104 (initiating a short position). Three months later, upon the expiry of the futures contract, the arbitrageur delivers the asset and secures a riskless profit of $1 ($104 futures price - $100 asset price - $3 carrying costs).
Related Terms: market-neutral, futures market, arbitrageur, acquisition cost, carrying costs, margin, short, open market, indexes, spreads.
