Cash and Carry Arbitrage
Arbitrage is a practice of taking benefit of price differences between two markets. A market-neutral strategy that combines purchasing of a long position in an asset such as stock or commodity and the sale of a position in the futures market on the same underlying asset is known as cash and carry arbitrage. In Cash and carry arbitrage, a trader takes the benefit of price differences between an asset and its derivative in different markets.
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How does It Work?
Initially, a trader identifies the various arbitrage opportunities available in the market. He then identifies and invests in mispriced securities. The trader goes long in a commodity while at the same time he takes a short position for the corresponding derivatives. The purchased commodity is held till the expiry date and the trader delivers the underlying against the corresponding contract and locks the profit. The profit earned by the trader is the purchase price of the asset plus its total carrying cost. When the corresponding contract is short, the trader locks in a sale at the price at which the contract is priced. The sale price is already determined and hence if the purchase price of the asset plus its carrying cost is less than the sale price of the contract, the trader makes a riskless profit from exploiting the mismatched prices.
Example:
Let’s assume that HUL currently trades at $ 205 in the market, with a total cost of $3 carrying costs associated with it. In addition, a futures contract is priced at $210. Mr. X an arbitrager identifies the opportunity and invests in the said stock and tries to make profits out of this mismatch using Cash and Carry arbitrage. He purchases the asset at $ 205 while at the same time he shorts the futures contract at $210, thus locking the sale price at $210. Mr. X holds the underlying until the delivery date of the futures and then delivers it on the date against the futures contract. The cost of underlying is $208 ($ 205 cost price + $3 carrying costs) and the locked sale price is $210 by shorting the futures. The investor here earns a profit of $3 by exploiting the mismatched prices of securities.
Limitations:
- The cost of underlying is certain, however, the carrying cost is uncertain.
- In case if the carrying cost increases beyond the locked-in sale price, the investor faces loss.
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Conclusion:
Arbitrage is a key component in trading. It is amongst the oldest and popular trading strategies. Cash and carry arbitrage basically exploit the mispricing between an underlying asset and financial derivative. In short, arbitragers help traders benefit in a risk-free manner.
Author: Urvi Surti
About the Author:
Urvi is a commerce graduate and has a keen interest in Finance. She has completed her Chartered Wealth Management (CWM) from the American Academy of Financial Management and is currently pursuing a career in Financial Risk Management (FRM).
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