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What is Cash-and-Carry-Arbitrage
Cash-and-carry-arbitrage is a market-neutral strategy combining the purchase of a long position in an asset such as a stock or commodity, and the sale (short) of a position in a futures contract on that same underlying asset. It aims to use pricing differences between the spot and futures market to make risk-free profits.
The futures contract must be theoretically expensive relative to the underlying asset, or the arbitrage won’t be profitable. There’s still risk that the carrying costs can increase.
Key Takeaways
- The strategy involves costs such as storage, insurance, and financing for physical assets, making securities less burdensome and often more profitable for arbitrage.
- The effectiveness of cash-and-carry arbitrage diminishes in well-established markets due to efficiency and low spreads, while less active markets may present better opportunities.
- Despite aiming for riskless profit, cash-and-carry arbitrage is subject to potential risks like increased carrying costs or changes in margin rates.
Understanding the Basics of Cash-and-Carry Arbitrage
In a cash-and-carry-arbitrage, the arbitrageur would typically seek to “carry” the asset until the expiration date of the futures contract, at which point it would be delivered against the futures contract. Therefore, this strategy is only viable if the cash inflow from the short futures position exceeds the acquisition cost and carrying costs on the long asset position.
Cash-and-carry arbitrage isn’t risk-free since carrying costs, like a rise in margin rates, can go up. Market movement risk is reduced because once a trade starts, the main event is delivering the asset against the futures contract. There is no need to access either one in the open market at expiration.
Physical assets like oil and grain need storage and insurance, while stock indexes like the S&P 500 mainly need financing costs. Therefore, arbitrage may be more profitable, all else held constant, in these non-physical markets. Lower barriers to entry mean more people can engage in arbitrage trades. This leads to more efficient pricing and lower spreads, which reduce profit opportunities.
Less active markets may still have arbitrage possibilities, as long as there is adequate liquidity on both sides of the game—spot and futures.
Practical Example of Cash-and-Carry Arbitrage in Action
Consider the following example of cash-and-carry-arbitrage. Assume an asset currently trades at $100, while the one-month futures contract is priced at $104. In addition, monthly carrying costs such as storage, insurance, and financing costs for this asset amount to $3.
In this case, the arbitrageur would buy the asset (or open a long position in it) at $100 and simultaneously sell the one-month futures contract (i.e. initiate a short position in it) at $104. The trader would then hold or carry the asset until the expiration date of the futures contract and deliver the asset against the contract, thereby ensuring an arbitrage or riskless profit of $1.
The Bottom Line
Cash-and-carry arbitrage is a strategy that seeks to exploit pricing inefficiencies between the spot market and the futures market. It takes a long position in the asset while shorting the futures contract. This strategy is market-neutral and aims for riskless profits, but it’s not without some risk, including increased carrying costs or changes in margin rates.
Cash-and-carry arbitrage can nonetheless be more accessible in non-physical markets like stock indexes due to lower barriers to participation. Liquidity is important in less active markets for the viability of these arbitrage opportunities.
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