What is Cash-and-Carry-Arbitrage

Cash-and-carry-arbitrage is a strategic approach that involves simultaneously buying an asset in the cash market and selling (shorting) a futures contract on the same underlying asset. This strategy aims to capitalize on price inconsistencies between the cash and futures markets to generate risk-free profits. For the arbitrage to be profitable, the futures contract should be priced higher than the underlying asset.

Key Takeaways

• Cash-and-carry arbitrage leverages pricing inefficiencies between the spot and futures markets by going long in the spot market and short on the futures contract.
• The concept involves “carrying” the asset for physical delivery until the expiration of the futures contract.
• While cash-and-carry-arbitrage offers the potential for riskless profits, there are associated costs with physically holding the asset until expiry.

Basics of Cash-and-Carry-Arbitrage

In a cash-and-carry-arbitrage scenario, the investor aims to retain the asset until the futures contract’s maturity date, at which point the asset gets delivered against the futures contract. This strategy proves fruitful only if the cash inflow from the short futures position surpasses the acquisition and carrying costs related to the long asset position.

While cash-and-carry arbitrage isn’t devoid of risks, such as potential increases in carrying costs like margin rate hikes, it effectively mitigates market movement risks typically encountered in regular trading. Once the trade is initiated, the primary event is the asset’s delivery against the futures contract, eliminating the need for further market exposure upon expiry.

Assets like oil barrels or grain tons entail storage and insurance costs, contrasting with non-physical assets like stock indexes that primarily incur financing expenses. Hence, non-physical markets may offer enhanced arbitrage opportunities due to lower operational costs. However, increased participation in arbitrage activities could entail lower profit margins due to tighter pricing alignments between spot and futures markets.

Even in less active markets, arbitrage prospects persist as long as there is sufficient liquidity on both the spot and futures sides.

Example of Cash-and-Carry Arbitrage

To illustrate cash-and-carry-arbitrage, suppose an asset is priced at $100, while a one-month futures contract for the same asset is valued at $104. Additionally, monthly carrying costs like storage, insurance, and financing amount to $3.

In this case, the arbitrageur would buy the asset at $100 and simultaneously sell the one-month futures contract at $104. By holding the asset until the futures contract expires and delivering it against the contract, the trader would secure a riskless profit of $1.