Cash-and-Carry-Arbitrage

Definition

Cash-and-carry arbitrage is a trading strategy in which an investor takes advantage of the price differences between a physical asset and its corresponding derivative contract. This is done by simultaneously purchasing the physical asset in the spot market and selling its related futures contract. The investor then holds the physical asset until the futures contract expires, profiting from the spread between the asset and futures prices.

Phonetic

Kash-and-Kari-Ahrbiht-rahzh

Key Takeaways

1. Cash-and-carry arbitrage is a trading strategy that involves simultaneously buying an asset in the spot market and selling it in the futures market (or vice versa) to profit from price discrepancies between the two markets.
2. The strategy requires carrying the purchased asset (for example, physically holding a commodity or holding a stock in your portfolio) until the maturity date of the futures contract, at which point you can “cash-and-carry” the asset, delivering it to close out the futures position and pocket the arbitrage profit.
3. This form of arbitrage is most commonly used in financial instruments that have a well-defined and easily accessible spot market, such as commodities, equities, and certain fixed income instruments. It helps to maintain price efficiency and convergence between the spot and futures markets.

Importance

Cash-and-Carry-Arbitrage is important in the business and finance realm as it ensures market efficiency by exploiting any pricing discrepancies between spot and futures prices of the same financial instrument. Through this risk-free trading strategy, investors simultaneously purchase an asset in the spot market while selling its equivalent futures contract, thereby locking in a predetermined profit margin that materializes upon the futures contract’s expiration. This process contributes to the alignment of spot and futures prices and safeguards a well-functioning market, which is vital for market participants looking for accurate price information to make informed decisions. Overall, cash-and-carry arbitrage plays a crucial role in maintaining market stability and fostering confidence in the financial system.

Explanation

Cash-and-carry arbitrage is a financial strategy primarily used by market participants to exploit the price discrepancies between the spot market and the futures market, thereby garnering risk-free profits. The purpose of this strategy is to capitalize on any inefficiencies present in the markets, particularly when the futures contract is trading at a significant premium to the underlying asset’s spot price. This premium, known as the basis, is attributed to the costs associated with carrying the asset (such as storage or financing costs) until the contract’s expiration. In a well-functioning market, the basis should be in line with these associated costs, but when a discrepancy arises, it creates an arbitrage opportunity. In a cash-and-carry arbitrage, an investor simultaneously buys the underlying asset in the spot market while simultaneously selling a futures contract. The proceeds from the futures sale help finance the purchase of the underlying asset, and the arbitrageur holds the asset until the futures contract’s expiration. Once the contract expires, the investor delivers the underlying asset against the short futures position, effectively “carrying” the asset until that point in time. In this manner, cash-and-carry arbitrage works to ensure that the price differences between the spot and futures markets do not deviate significantly from finance and storage costs. This equilibrating effect contributes to market efficiency, as it provides price signals that help market participants make informed decisions.

Examples

Example 1: Stock and Dividend ArbitrageAn investor notices that the same stock is trading at $50 on the New York Stock Exchange (NYSE) and at $50.50 on the London Stock Exchange (LSE). Due to the discrepancy in prices, the investor decides to purchase the stock for $50 on the NYSE and simultaneously sell it for $50.50 on the LSE, making an instant, risk-free profit of $0.50 per share. With cash-and-carry arbitrage, the investor carries out this strategy with the expectation that the price difference will eventually converge. Example 2: Commodity Futures MarketIn the commodity futures market, a trader notices that the spot price of an agricultural product, such as corn, is lower than the price of corn futures (the price at which the product will be sold in the future). The trader decides to buy the corn at the lower spot price, store it, and simultaneously sell the corn futures contract. When the futures contract expires, the trader delivers the stored corn and profits from the price difference between the spot price and the futures price. The cash-and-carry arbitrage strategy allows the trader to lock in a risk-free profit, taking advantage of the mispricing between the spot and futures markets. Example 3: Foreign Currency MarketA currency trader observes that the U.S. dollar is trading at a lower value compared to the British pound in the spot market than in the forward market (a market where currencies are exchanged at a specified future date). The trader buys U.S. dollars at the lower spot price and simultaneously sells the same amount of U.S. dollars in the forward market, effectively carrying out a cash-and-carry arbitrage strategy. Upon the expiration of the forward contracts, the trader delivers the U.S. dollars and profits from the difference in exchange rates between the spot and forward markets. This is another example of exploiting market inefficiencies to lock in a risk-free profit.

Frequently Asked Questions(FAQ)

Related Finance Terms

• Spot Market
• Forward Market
• Arbitrage Opportunity
• Risk-free Profit
• Physical Delivery

Sources for More Information

• Investopedia
• Corporate Finance Institute
• Coursera
• The Business Professor