Introduction
Have you ever considered making money in trading without risking much or predicting market directions? If so, exploring cash and carry arbitrage could be intriguing. It is a strategy that stays neutral to market movements and capitalizes on price differences between an asset and its futures contract. Let's understand this method of smart trading in detail.
What is Cash and Carry Arbitrage?
Cash and carry arbitrage are based on the principle of the law of one price. This states that two identical assets should have the same price in an efficient market. However, in reality, there may be temporary or persistent discrepancies between the prices of the same asset in distinct markets due to transaction costs, supply and demand, liquidity, taxes, and regulations.
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Cash and carry arbitrage exploit these price differences by buying the asset in the spot market, where it is cheaper, and selling it in the futures market, where it is more expensive. The spot market is the market where the asset is traded for immediate delivery. The futures market is where the asset is traded for delivery at a stated date in the future.
The arbitrageur holds the asset until the expiration date of the futures contract. Then, he delivers it against the contract. The profit is locked when the trade begins, and it is the gap between the futures and spot prices minus the costs of holding the asset (carrying costs).
Examples of Cash and Carry Arbitrage
Example 1:
Suppose you find that the spot price of gold is Rs. 50,000 per 10 grams, while the futures price for delivery in one month is Rs. 51,000 per 10 grams. The interest rate is 10% annually, and the storage cost is Rs. 100 per 10 grams monthly. You can execute cash and carry arbitrage by buying 10 grams of gold in the spot market for Rs. 50,000, selling the futures contract for Rs. 51,000, and holding the gold until expiration. Your profit will be:
Profit = Futures Price - Spot Price - Carrying Cost
= Rs. 51,000 - Rs. 50,000 - (Rs. 50,000 x 10% x 1/12 + Rs. 100)
= Rs. 833.33
Example 2:
Suppose you find that the spot price of a stock is Rs. 100, while the futures price for delivery in one month is Rs. 102. The interest rate is 10% per annum, and the stock pays a dividend of Rs. 2 per share in one month. You can execute cash and carry arbitrage by buying one share of the stock in the spot market for Rs. 100, selling the futures contract for Rs. 102, and holding the stock until expiration. Your profit will be:
Profit = Futures Price - Spot Price - Carrying Cost + Dividend
= Rs. 102 - Rs. 100 - (Rs. 100 x 10% x 1/12) + Rs. 2
= Rs. 1.67
Here, the profit is lower than in the previous example because you have to deduct the interest cost from the price difference and add the dividend you receive from the stock.
What are the benefits and challenges of Cash and Carry Arbitrage?
Cash and carry arbitrage has several benefits, such as:
- It is a risk-free strategy. Here, the profit is guaranteed when entering the trade, regardless of the market movements.
- Cash Carry Arbitrage is a market-neutral strategy. It does not depend on the market's direction but only on the price difference between the spot and the futures market.
However, this strategy also faces some challenges, such as:
- It requires access to both the spot and the futures market for the same asset, which may not be available or feasible for some traders.
- It demands sufficient capital and margin to execute the trade, as the arbitrageur has to buy the asset in the spot market and sell it in the futures market simultaneously.
- It involves carrying costs, which may reduce or eliminate the profit margin, depending on the type and duration of the asset.
- This strategy may be subject to competition from other arbitrageurs, who may quickly close the price gap and eliminate the arbitrage opportunity.
Conclusion
Cash and carry arbitrage is a risk-free trading strategy exploiting price differences by buying and selling the same asset in different markets. It demands access to both spot and futures markets, along with substantial capital, margin, and carrying costs. However, market friction and competition may affect its success.
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