Cash-and-Carry Arbitrage: Definition and Example

Cash-and-Carry Arbitrage: Definition and Example

In the world of financial futures trading, one strategy that traders often employ is called cash-and-carry arbitrage. This strategy involves taking advantage of price discrepancies between the spot market and the futures market to make a profit.

What is Cash-and-Carry Arbitrage?

Cash-and-carry arbitrage is a trading strategy that involves buying an asset in the spot market and simultaneously selling a futures contract for the same asset. The goal is to profit from the price difference between the spot price and the futures price.

For example, let’s say the spot price of gold is $1,500 per ounce, and the futures price for gold is $1,550 per ounce. A trader could buy gold in the spot market for $1,500 per ounce and sell a futures contract for $1,550 per ounce. This would result in a profit of $50 per ounce.

How does Cash-and-Carry Arbitrage work?

The key to cash-and-carry arbitrage is the concept of carrying costs. Carrying costs refer to the costs associated with holding an asset, such as storage costs, insurance, and financing costs. In the case of cash-and-carry arbitrage, the trader is essentially buying the asset in the spot market and selling it in the futures market to lock in a profit.

By buying the asset in the spot market, the trader incurs the carrying costs associated with holding the asset. However, by simultaneously selling a futures contract, the trader is able to offset these carrying costs and lock in a profit.

Benefits of Cash-and-Carry Arbitrage

There are several benefits to using cash-and-carry arbitrage as a trading strategy. First, it allows traders to take advantage of price discrepancies between the spot market and the futures market, which can result in significant profits. Second, it helps to ensure market efficiency by narrowing the price difference between the spot price and the futures price. Finally, it provides an opportunity for traders to hedge their positions and manage risk.

Risks of Cash-and-Carry Arbitrage

While cash-and-carry arbitrage can be a profitable strategy, it is not without risks. One of the main risks is the possibility of the price difference between the spot market and the futures market narrowing or disappearing altogether. If this happens, the trader may not be able to make a profit or may even incur a loss. Additionally, there is always the risk of market volatility and unexpected events that can impact the price of the asset.

Overall, cash-and-carry arbitrage is a trading strategy that can be used to take advantage of price discrepancies between the spot market and the futures market. It involves buying an asset in the spot market and simultaneously selling a futures contract to lock in a profit. While there are risks involved, this strategy can be a valuable tool for traders looking to profit from market inefficiencies.

Advantages	Disadvantages
Profit from price discrepancies	Possibility of price difference narrowing
Market efficiency	Market volatility
Risk management	Unexpected events

Example: Let’s say the spot price of crude oil is $60 per barrel, and the futures price for crude oil is $65 per barrel. A trader could buy crude oil in the spot market for $60 per barrel and sell a futures contract for $65 per barrel. This would result in a profit of $5 per barrel.

What is Cash-and-Carry Arbitrage?

Cash-and-Carry Arbitrage is a financial strategy that involves taking advantage of price discrepancies between the spot market and the futures market. It is a type of arbitrage where an investor can profit from the difference in prices by simultaneously buying and selling an asset.

In simple terms, Cash-and-Carry Arbitrage involves buying an asset in the spot market and simultaneously selling a related futures contract. The goal is to lock in a profit by exploiting the price difference between the two markets.

How does Cash-and-Carry Arbitrage work?

To understand how Cash-and-Carry Arbitrage works, let’s consider an example with a commodity like gold:

1. An investor buys gold in the spot market at a lower price.

2. At the same time, the investor sells a futures contract for gold at a higher price.

3. The investor holds the physical gold and waits for the futures contract to expire.

4. When the futures contract expires, the investor delivers the physical gold to fulfill the contract.

5. The investor earns a profit from the price difference between the spot market and the futures market.

This strategy works because the futures market often prices in the cost of carrying the asset, such as storage and financing costs. By buying the asset in the spot market and simultaneously selling a futures contract, the investor can effectively lock in a profit.

Benefits of Cash-and-Carry Arbitrage

Cash-and-Carry Arbitrage offers several benefits to investors:

1. Profit potential: By taking advantage of price discrepancies, investors can earn a profit without taking on significant market risk.

2. Diversification: Cash-and-Carry Arbitrage allows investors to diversify their portfolios and potentially reduce overall risk.

3. Hedging opportunities: This strategy can also be used to hedge against potential losses in other investments.

Risks of Cash-and-Carry Arbitrage

While Cash-and-Carry Arbitrage can be profitable, it also carries certain risks:

1. Execution risk: There is a risk that the price discrepancy may not be as expected, resulting in a loss or lower profit.

2. Market risk: Changes in market conditions, such as interest rates or supply and demand dynamics, can impact the profitability of the arbitrage strategy.

3. Counterparty risk: Investors need to consider the creditworthiness of the counterparty when entering into futures contracts.

Overall, Cash-and-Carry Arbitrage is a strategy that can be used by investors to take advantage of price discrepancies between the spot market and the futures market. It offers the potential for profit and diversification, but also carries certain risks that need to be carefully considered.

How does Cash-and-Carry Arbitrage work?

Cash-and-Carry Arbitrage is a trading strategy that takes advantage of price discrepancies between the spot market and the futures market. It involves buying an asset in the spot market and simultaneously selling a futures contract for the same asset. The goal is to profit from the price difference between the two markets.

Step 1: Identify a Price Discrepancy

Step 2: Buy the Asset in the Spot Market

Once a price discrepancy is identified, the trader will buy the asset in the spot market at the lower price. This could be a physical commodity, such as gold or oil, or a financial instrument, such as a stock or currency.

Step 3: Sell a Futures Contract

Simultaneously with buying the asset in the spot market, the trader will sell a futures contract for the same asset in the futures market. The futures contract represents an agreement to buy or sell the asset at a predetermined price and date in the future.

Step 4: Wait for Convergence

After executing the cash-and-carry trade, the trader will wait for the spot price and the futures price to converge. This means that the price difference between the two markets narrows down or disappears completely.

Step 5: Close the Position

Once the spot price and the futures price have converged, the trader will close the position by selling the asset in the spot market and buying back the futures contract in the futures market. The profit is made from the price difference between the initial trade and the closing trade.

Cash-and-Carry Arbitrage can be a profitable trading strategy when executed correctly. However, it requires careful monitoring of the markets and quick execution of trades to take advantage of price discrepancies. It is important to note that arbitrage opportunities may be short-lived and may disappear as market participants react to the price discrepancies.

Benefits of Cash-and-Carry Arbitrage

Cash-and-Carry Arbitrage offers several benefits for traders and investors looking to profit from price discrepancies in financial futures trading:

1. Profit Potential

One of the main benefits of Cash-and-Carry Arbitrage is the potential for significant profits. By taking advantage of price differences between the spot market and the futures market, traders can buy low in the spot market and sell high in the futures market, earning a profit on the price difference.

2. Risk Mitigation

Cash-and-Carry Arbitrage can also help mitigate risks in financial futures trading. By simultaneously buying and selling assets, traders can hedge their positions and reduce their exposure to market fluctuations. This can help protect against potential losses and provide a more stable investment strategy.

3. Market Efficiency

Cash-and-Carry Arbitrage plays a crucial role in promoting market efficiency. When traders exploit price discrepancies, they help bring prices in line with their true value. This helps to eliminate market inefficiencies and ensures that prices accurately reflect the underlying assets.

4. Diversification Opportunities

Cash-and-Carry Arbitrage allows traders to diversify their portfolios by investing in different markets and assets. By taking advantage of price differences across various markets, traders can spread their risk and potentially increase their overall returns.

5. Liquidity Provision

Cash-and-Carry Arbitrage can also contribute to market liquidity. By actively buying and selling assets, arbitrageurs provide liquidity to the market, making it easier for other traders to enter and exit positions. This increased liquidity can lead to more efficient price discovery and smoother market operations.

Risks of Cash-and-Carry Arbitrage

1. Market Risk

Market risk refers to the potential for the price of the underlying assets to change, which can result in financial losses. In the case of Cash-and-Carry Arbitrage, if the price of the underlying asset decreases significantly, it may result in a loss for the trader.

2. Execution Risk

Execution risk refers to the potential for errors or delays in executing the arbitrage strategy. This can occur due to technical issues, market disruptions, or human error. If the trader is unable to execute the strategy in a timely manner, it may result in missed opportunities or losses.

3. Counterparty Risk

Counterparty risk refers to the risk that the other party involved in the arbitrage transaction may default on their obligations. In Cash-and-Carry Arbitrage, this typically refers to the risk that the buyer of the futures contract may default on their payment or delivery obligations. This can result in financial losses for the trader.

4. Liquidity Risk

Liquidity risk refers to the risk of not being able to buy or sell assets quickly and at a fair price. In Cash-and-Carry Arbitrage, if the market for the underlying asset or the futures contract is illiquid, it may be difficult to execute the arbitrage strategy or to exit the position at a desired price.

5. Regulatory Risk

Regulatory risk refers to the risk of changes in regulations or laws that may impact the profitability or legality of the arbitrage strategy. Traders engaging in Cash-and-Carry Arbitrage should be aware of any regulatory changes that may affect their trading activities.

6. Currency Risk

Currency risk refers to the risk of fluctuations in exchange rates between different currencies. In Cash-and-Carry Arbitrage, if the trader is dealing with assets or contracts denominated in different currencies, changes in exchange rates can impact the profitability of the arbitrage strategy.

It is important for traders to carefully consider these risks and to have a risk management plan in place when engaging in Cash-and-Carry Arbitrage. This may include setting stop-loss orders, diversifying investments, and staying informed about market conditions and regulatory changes.

Risk	Description
Market Risk	Potential for price changes in underlying assets
Execution Risk	Potential for errors or delays in executing the arbitrage strategy
Counterparty Risk	Risk of the other party defaulting on their obligations
Liquidity Risk	Risk of illiquid markets impacting execution or exit prices
Regulatory Risk	Risk of regulatory changes impacting profitability or legality
Currency Risk	Risk of fluctuations in exchange rates

Example of Cash-and-Carry Arbitrage

Let’s take a look at a real-life example to better understand how cash-and-carry arbitrage works. Suppose there is a commodity, such as gold, that is traded in both the spot market and the futures market.

Step 1: Spot Market

In the spot market, the current price of gold is $1,500 per ounce. An investor believes that the price of gold will increase in the future.

Step 2: Futures Market

In the futures market, the investor enters into a contract to buy gold at a future date (let’s say 3 months from now) for $1,550 per ounce.

Step 3: Borrowing Funds

The investor borrows funds at an interest rate of 2% per annum to finance the purchase of gold in the spot market.

Step 4: Buying Gold in the Spot Market

The investor uses the borrowed funds to buy gold in the spot market at the current price of $1,500 per ounce.

Step 5: Storing Gold

The investor stores the purchased gold in a secure facility, incurring storage costs of $10 per month.

Step 6: Selling Gold in the Futures Market

After 3 months, the investor sells the gold in the futures market at the agreed price of $1,550 per ounce.

Step 7: Repaying the Loan

The investor repays the borrowed funds, including the interest, using the proceeds from selling the gold in the futures market.

Step 8: Calculating Profit

The profit from cash-and-carry arbitrage is calculated by subtracting the initial investment (purchase price in the spot market plus borrowing costs) from the final proceeds (selling price in the futures market minus storage costs and loan repayment).