Cash-and-Carry Arbitrage
Cash-and-carry arbitrage is a strategy aimed at exploiting price discrepancies between the cash (or spot) market and the futures market of an asset. This approach involves purchasing the asset at the current market price while concurrently selling a futures contract on the same asset when the futures are priced higher than the spot price, adjusted for carrying costs. The profit is realized by holding the asset until the futures contract expires, then delivering the asset against the contract. While it aims to secure riskless profits by leveraging market inefficiencies, the strategy incurs carrying costs and risks associated with changes in these costs.
Strategy Fundamentals
The core of cash-and-carry arbitrage involves holding an asset until the maturity of a corresponding short futures position, balancing the costs of owning the asset against the income from the futures. This strategy hinges on the futures contract being priced significantly above the spot price plus carrying costs, including storage, insurance, and financing. Although designed to be market-neutral, factors like rising carrying costs can introduce risks.
Risk Considerations
While cash-and-carry arbitrage aims to mitigate market movement risks through its structure, it's not devoid of risk. The primary risk arises from potential increases in carrying costs, which could erode expected profits. Moreover, physical assets entail additional considerations such as storage and insurance, unlike financial instruments that primarily involve financing costs.
Market Efficiency and Arbitrage Opportunities
The accessibility of cash-and-carry arbitrage contributes to market efficiency, narrowing the price gap between spot and futures markets. While this reduces profit margins, opportunities still exist, particularly in less active markets with sufficient liquidity. However, the competitive nature of arbitrage means that these opportunities may be fleeting.
Practical Example
Imagine an asset in the spot market priced at $150 and a two-month futures contract priced at $157. The total monthly carrying costs are $4. By purchasing the asset for $150 and shorting the futures contract at $157, an arbitrageur commits to carrying the asset for two months. Upon contract expiration, the asset is delivered in fulfillment of the futures contract, realizing a profit of $3 after accounting for the $8 carrying cost.