Cash and Carry Arbitrage

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As a cash-and-carry arbitrage refers to a strategy in the financial markets, where a price imbalance between the cash market and the futures market is exploited to a risk-free profit to achieve ( arbitrage in the narrow sense).

Cash-and-carry arbitrage is always possible when the forward price (price on the futures market) of a financial asset is too high compared to its spot price (price on the cash market). The arbitrageur sells the value forwards, at the same time buys it to hedge it on the cash market (“cash”) and holds it (“carry”) until the futures sale is due.

How it works and example

The prerequisite for cash-and-carry arbitrage is that the forward price, which is formed on the futures markets for a certain financial value, is above the theoretical forward price for this value. The theoretical forward price depends on the spot price of the asset , the refinancing interest and any income from the financial asset ( interest payments , dividends ). The sales proceeds from the excessively high forward price exceed the costs of the immediate acquisition of the value and the refinancing costs arising from the purchase (taking into account any income), so that a profit remains. Since the arbitrageur has the value to be delivered when the futures contract matures through the cash purchase, further price fluctuations no longer influence his profit.

Sample calculation: A share (for which no dividend is paid) is quoted on the cash market at EUR 100. The forward rate for a year from now is EUR 105. The interest for a one-year term is 4.5%, so that the theoretical forward price would be EUR 104.50. The arbitrageur does the following:

  • He sells the share for 1 year at EUR 105 per term
  • He buys the share on the cash market for EUR 100.
  • He borrows the money for this with a one-year term at a fixed interest rate of 4.5%

When the futures contract is due in one year, he delivers the share from his portfolio . For this he receives 105 EUR, with which he pays the 100 EUR loan repayment and the 4.50 EUR interest. He has 50 cents of risk-free profit left.

In reality, transaction costs and bid-ask spreads still have to be taken into account. For this reason, the difference between the theoretical and actual forward price must have a certain minimum size so that the cash-and-carry arbitrage is worthwhile (arbitrage channel).

Risks

Cash-and-carry arbitrage is not subject to any market price risk, but it is not completely risk-free. It is essential that the futures business partner fulfills his obligations when they fall due ( counterparty risk ). If the futures sale is carried out on a futures exchange , this counterparty risk does not apply. For this, the arbitrageur may have to pay collateral to the futures exchange in the meantime ( margin payments), which exposes him to a certain liquidity risk .

Reverse cash and carry arbitrage

If the forward price is too low (or the spot price too high), reverse cash-and-carry arbitrage can be carried out. To do this, the arbitrageur has to borrow and sell the value as well as repurchase it on a forward basis, mirroring the cash-and-carry arbitrage. He invests the purchase proceeds for the term of the futures contract at a fixed interest rate.

If the arbitrage business relates to a security , the cash sale is a short sale . If the arbitrageur is unable to borrow the security from the outset for the entire term of the arbitrage , he runs the risk of not being able to borrow the security again when the securities loan expires. In this case, he would have to terminate the arbitrage business prematurely. The hedge against market price risks inherent in the arbitrage business would then no longer be effective and the arbitrageur may suffer losses from price fluctuations in the security.

Remarks

  1. ↑ This serves to simplify the calculation example

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