Introduction
Reverse cash and carry arbitrage involves selling an asset in the spot market and buying a futures contract for the same asset at a lower price. This strategy aims to lock in a profit by taking advantage of the difference between the spot and futures prices.
You can buy or sell an asset for immediate delivery in the spot market. For example, if you want to buy gold today, you can pay the spot price to a jeweler. The futures market is where you can deal in an asset for delivery at a specified date in the future. For example, if you want to buy some gold in six months, you can enter into a futures contract and agree to pay the futures price.
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Spot and future prices of an asset often differ. Sometimes, the spot price is higher than the futures price. This is called backwardation. It occurs when the demand for the asset is high in the present but is expected to be low in the future. For example, if there is a shortage of wheat in the market, the spot price of wheat will be higher than the futures price because people want to buy wheat now, not later.
That is where reverse cash and carry arbitrage come in.
How to Execute Reverse Cash and Carry Arbitrage?
Let's see how reverse cash and carry arbitrage work with a numerical example. Suppose the wheat spot price is Rs. 25 per kg, and the futures price of wheat for delivery in six months is Rs. 20 per kg. You have Rs. 10,000 to invest in this arbitrage opportunity. Here are the steps you need to follow:
- Step 1: Short-sell 400 kg of wheat in the spot market at Rs. 25 per kg and receive Rs. 10,000 as proceeds.
- Step 2: Buy one futures contract for 400 kg of wheat at Rs. 20 per kg and pay Rs 8,000 as a margin (20% of the contract value).
- Step 3: Hold the positions until the expiration of the futures contract in six months.
- Step 4: Accept 400 kg of wheat delivery and use it to cover your short position in the spot market.
- Step 5: Calculate your arbitrage profit by subtracting the futures and carrying costs from the spot price.
The carrying costs of the short position are the costs associated with borrowing and maintaining the asset you have sold. These include interest, dividends, storage fees, insurance, etc. For simplicity, let's assume that the carrying costs are Rs. 0.5 per kg per six months. Therefore, the carrying costs for 400 kg of wheat are Rs. 200.
Your arbitrage profit is:
Spot price - Futures price - Carrying costs
= Rs. 25 - Rs. 20 - Rs. 0.5
= Rs. 4.5 per kg
For 400 kg of wheat, your total arbitrage profit is:
= Rs. 4.5 x 400
= Rs. 1,800
That is an 18% return on your initial investment of Rs. 10,000 in six months without taking any risk!
What factors affect the profitability of Reverse Cash and Carry Arbitrage?
Several factors can affect the profitability of this strategy, such as:
- Degree of backwardation: The larger the difference between the spot and futures prices, the higher the potential arbitrage profit. However, backwardation may not last for long, as the market forces will tend to eliminate the price gap. Therefore, you need to act fast and monitor the market conditions closely.
- Carrying costs of the short position: The higher the carrying costs, the lower the arbitrage profit. Choose non-perishable, non-dividend paying, and easily stored commodities or assets if possible.
- Price risk: The assumption behind reverse cash and carry arbitrage is that the future and spot prices will converge at the expiration of the futures contract. However, this may not always happen due to unforeseen events or market inefficiencies. For example, if the spot price of wheat drops below the futures price, you will incur a loss instead of a profit. Therefore, you need to hedge your positions and manage your risk carefully.
- Liquidity: The success of this strategy depends on the ability to purchase and sell the asset and the futures contract at the desired prices and quantities. However, this may not always be possible due to limited supply, demand, or trading volume.
Conclusion
In reverse cash and carry arbitrage, you sell an asset at its current price and buy a futures contract for the same asset at a lower cost, aiming to profit from the difference between the two prices. The profitability of this strategy relies on backwardation level, carrying costs, price convergence or divergence risk, and liquidity of the underlying asset.
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