What is Cash-and-Carry-Arbitrage

What is Cash-and-Carry-Arbitrage

Let me explain cash-and-carry-arbitrage to you directly: it's a market-neutral strategy where you combine buying a long position in an asset like a stock or commodity, and selling short a futures contract on that same asset. You're looking to exploit pricing inefficiencies between the cash or spot market and the futures market to lock in riskless profits. For this to work, the futures contract has to be theoretically overpriced compared to the underlying asset; otherwise, there's no profit in it.

Key Takeaways

You need to grasp that cash-and-carry arbitrage is all about spotting and acting on pricing gaps between spot and futures markets—you go long in the spot market and short the futures contract. The core idea is to carry the asset physically until the futures expiry date for delivery. Remember, it's not completely risk-free because carrying the asset involves costs like storage or financing that could eat into your profits.

Basics of Cash-and-Carry-Arbitrage

In this strategy, you as the arbitrageur would carry the asset right up to the futures contract's expiration, then deliver it against the contract. It's only worth doing if the cash from shorting the futures beats out the cost of buying and holding the asset, including all carrying expenses.

These positions aren't entirely risk-free—you might face hikes in carrying costs, like if your broker ups the margin rates. That said, the big market movement risks you see in regular trades are mostly eliminated because once you set it up, it's just about delivering the asset at expiration without hitting the open market.

For physical assets like oil barrels or grain tons, you'll deal with storage and insurance costs, but for something like the S&P 500 Index, it's mainly financing costs such as margin. This can make arbitrage more profitable in non-physical markets, assuming everything else is equal. However, lower barriers mean more people jump in, leading to tighter pricing between spot and futures, which shrinks the spreads and your profit chances.

You'll still find opportunities in less active markets, provided there's enough liquidity in both spot and futures sides.

Example of Cash-and-Carry Arbitrage

Take this straightforward example to see how it works: suppose an asset is trading at $100 in the spot market, and the one-month futures contract is at $104. Add in monthly carrying costs—storage, insurance, financing—totaling $3.

You'd buy the asset at $100 for a long position and sell the futures contract short at $104. Then, you carry the asset until expiration and deliver it against the contract, securing a riskless profit of $1 after costs.