Cash and Carry Arbitrage: Definition, Strategy & Examples

Cash and carry arbitrage is a financial arbitrage strategy that involves exploiting the mispricingMispricingMispricing causes a divergence between the market price of a security and the fundamental value of that security. The law of one price states that the market price of a security is equal to the present discounted value of all cash flows generated by the security. However, it is not always the case between an underlying asset and the financial derivative corresponding to it. Using the cash and carry arbitrage strategy, a trader aims to use market pricing discrepancies between the underlying(s) and the derivative to their advantage by exploiting the opportunity to generate profits via a correction in the mispricing. The strategy is sometimes also referred to as basis trading.

Summary

• Cash and carry arbitrage is a financial arbitrage strategy that involves the exploitation of the mispricing between an underlying asset and the financial derivative corresponding to it.
• Using the cash and carry arbitrage strategy, a trader aims to use market pricing discrepancies between the underlying(s) and the derivative to their advantage by exploiting the opportunity to generate profits via a correction in the mispricing.
• Traders secure a profit by taking a long position on the financial commodity and shorting the corresponding contract.

How It Works

A trader implements a cash and carry arbitrage strategy by identifying lucrative arbitrage opportunities in the market. They identify and invest in securities that they identify as mispriced in relation to each other. The trader opts to go long in a commodity while, at the same time, taking a short positionLong and Short PositionsIn investing, long and short positions represent directional bets by investors that a security will either go up (when long) or down (when short). In the trading of assets, an investor can take two types of positions: long and short. An investor can either buy an asset (going long), or sell it (going short). for the corresponding financial derivative and selling it off.

The commodity purchased is held until the expiration dateExpiration Date (Derivatives)The expiration date refers to the date in which options or futures contracts expire. It is the last day of the validity of the derivatives contract., i.e., the delivery date of the corresponding contract. The trader then delivers the underlying against the corresponding contract and locks in a riskless profit. The profit earned by the trader is determined by the purchase price of the underlying plus its total carrying cost.

By shorting the corresponding contract, the investor locks in a sale at the price at which the contract is priced. Hence, the investor will already have determined the sale price. If the purchase price of the underlying plus its carrying cost is less than the price at which the contract is sold, the trader makes a riskless profit by exploiting this mismatch of prices.

Example of Cash and Carry Arbitrage

Say, for example, that an underlying asset currently trades at $102 in the market, with a total of $3 worth of carrying costs associated with it. Additionally, there is a futures contractFutures ContractA futures contract is an agreement to buy or sell an underlying asset at a later date for a predetermined price. It’s also known as a derivative because future contracts derive their value from an underlying asset. Investors may purchase the right to buy or sell the underlying asset at a later date for a predetermined price. priced at $108. An investor identifies said securities in the market and invests in them, with an aim to arbitrage a profit out of the securities using the cash and carry strategy.

The investor purchases the underlying at $102, opting for a long position. He simultaneously also shorts the futures contract at $108 and sells it off. By shorting the futures contract, the investor locks in a sale at $108. The investor will hold the underlying until the delivery date (i.e., expiration date) of the futures and then delivers it on the date against the futures contract.

Now, the cost of the underlying is $105 (the cost it was priced at plus its carrying cost), but the sale locked in by the investor was $108 by shorting the futures. The investor hence arbitrages a profit of $3 by exploiting the mispricing between the securities to their advantage.

Risks Associated with Cash and Carry Arbitrage

In cash and carry arbitrage, the acquisition cost of the underlying is certain; however, there is no certainty with regards to its carrying costs. In the event that the carrying costs of the underlying increase and rise beyond the locked-in sale price of the corresponding contract, the investor incurs a loss instead of a profit. An example of an increase in carrying costs is the rising margin rates by brokerage firms.

More Resources

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