Cash and Carry Arbitrage in Stock Market

Arbitrage strategies in financial markets are examined to understand how price differences arise across related instruments and timeframes. In equity derivatives, spot and futures markets often move in tandem, yet temporary pricing gaps may appear due to factors such as interest rates, liquidity conditions, and contract maturity structures.

This article examines cash and carry arbitrage as a market mechanism observed in stock markets. It explains how spot–futures pricing relationships are analysed, how such positions are structured, and how costs, risks, and settlement processes influence outcomes under normal market conditions.

Cash and carry arbitrage refers to a market situation where an underlying asset is purchased in the spot market while a futures contract on the same asset is sold simultaneously, when the futures price exceeds the spot price adjusted for carrying costs. Carrying costs typically include financing expenses, storage costs where applicable, and income foregone, such as dividends, over the life of the futures contract.

The price gap between the spot and futures markets reflects this cost structure and forms the basis of the arbitrage spread observed at a given point in time. Such pricing relationships are monitored across various stocks, including segments where pricing inefficiencies are analysed alongside broader equity trends, such as assessments related to the most undervalued stocks in India.

Cash and carry arbitrage is conceptually distinct from reverse cash and carry arbitrage, where the futures price trades below the spot price after adjusting for carrying costs, leading to an opposite positioning across markets.

​​The structure of cash and carry arbitrage is based on maintaining offsetting positions in the spot and futures markets until contract maturity. The process reflects how pricing alignment is expected to occur between these two markets over time.

• Spot Market Position: The asset is acquired in the spot market at the prevailing market price, establishing ownership for the duration of the futures contract.
  

• Futures Market Position: A futures contract for the same quantity and expiry is sold at the quoted futures price.
  

• Carrying Costs Consideration: Financing costs, storage expenses where applicable, and income foregone during the holding period are factored into the overall price relationship.
  

• Holding Period: Both positions are maintained until the futures contract approaches expiry, during which the spot and futures prices typically converge.
  

• Settlement: At expiry, the futures position is settled in accordance with exchange rules, and the spot position offsets the contractual obligation.
   

The arbitrage spread observed in this structure arises when the futures price remains higher than the spot price after adjusting for carrying costs, reflecting prevailing market conditions rather than guaranteed outcomes.

The execution of cash and carry arbitrage involves aligning spot market transactions with futures positions to capture price differentials that exist at a given point in time. Each step plays a role in ensuring that the pricing relationship between the cash and futures markets is reflected accurately after accounting for holding-related costs.

Step 1: Identification of the Price Differential

The process begins by observing the relationship between the spot price (S) of the underlying asset and its futures price (F). A cash and carry structure exists when the futures price exceeds the spot price after factoring in expected holding costs over the contract period.

Step 2: Purchase in the Spot Market

The underlying asset is acquired in the cash market at the prevailing spot price. This establishes ownership of the asset that corresponds to the futures position created simultaneously.

Step 3: Sale of the Futures Contract

An equivalent quantity of futures contracts is sold at the quoted futures price for the same expiry. This locks in the forward selling price, forming the second leg of the arbitrage position.

Step 4: Holding Period and Cost Consideration

During the holding period, the asset remains in possession until the futures contract approaches expiry. Costs incurred during this phase collectively form the cost of carry and typically include:

• Financing or interest costs on capital deployed to purchase the asset

• Opportunity cost arising from dividends forgone during the holding period

• Storage or custody-related charges, where applicable

• Statutory charges, taxes, and transaction-related expenses
   

These components directly affect the net spread between the spot and futures prices and determine whether the pricing difference remains intact over the contract duration.

Step 5: Settlement at Expiry

At futures expiry, the asset is either delivered against the futures contract or the position is closed through offsetting trades, depending on the settlement mechanism of the contract. The realised outcome reflects the difference between the locked-in futures price and the adjusted cost of holding the asset.

Arbitrage Profit Formula
Arbitrage Profit = Futures Price (F) − Spot Price (S) − Cost of Carry

Sub-note:
The cash and carry framework remains structurally valid as long as the futures and spot prices converge at expiry and the cumulative holding costs remain within the observed price differential.

The pricing relationship between the spot and futures markets can be illustrated through a hypothetical example based on prevailing market conditions.

• Spot price of stock XYZ: ₹1,000

• Futures price (3-month contract): ₹1,050

• Cost of carry for 3 months (financing and foregone dividends): ₹20

• Transaction costs (brokerage and statutory charges): ₹5
   

The arbitrage spread is derived as follows:

Futures Price (₹1,050) − Spot Price (₹1,000) − Cost of Carry (₹20) − Transaction Costs (₹5)
= ₹25 per share

This spread represents the price difference available between the spot and futures markets after accounting for carrying and transaction costs. The actual outcome depends on settlement conditions, contract specifications, and market convergence at expiry.

In cash and carry arbitrage, the price difference between the spot and futures markets is assessed alongside the costs associated with holding the underlying asset until contract expiry. These holding-related expenses directly influence whether a price gap translates into a measurable arbitrage spread.

Carrying costs refer to the expenses incurred while maintaining ownership of an asset over the duration of a futures contract. These typically include financing costs such as interest on capital used to purchase the asset, storage or warehousing charges in the case of physical commodities, and opportunity costs like dividends or benefits that are foregone during the holding period. When evaluating cash and carry arbitrage positions, these costs are accounted for against the spot–futures price difference to assess the net spread implied by the trade.

Cash and carry arbitrage is subject to several structural and market-related constraints that influence how price differences behave over the contract period.

• Price Convergence Risk: Futures prices may not align fully with spot prices at expiry due to market disruptions or contract-specific factors.
  

• Transaction Costs: Brokerage charges, statutory levies, and financing expenses can reduce or offset observed price spreads.
  

• Liquidity Constraints: Limited liquidity in either the spot or futures market can affect execution and settlement efficiency.
  

• Regulatory and Operational Factors: Margin requirements, settlement timelines, and regulatory changes may influence position management.
  

• Timing and Holding Period Factors: Variations in contract duration and interim market conditions can affect pricing behaviour during the holding period.
   

These limitations reflect how arbitrage outcomes are shaped by market structure, cost variables, and regulatory frameworks.

Cash and carry arbitrage represents a pricing mechanism observed between spot and futures markets, where differences arise due to carrying costs, contract structure, and market conditions. It is commonly described as a low-risk strategy because of its reliance on predefined price relationships rather than directional price movement.

The effectiveness of this approach is influenced by factors such as transaction costs, liquidity, regulatory requirements, and settlement dynamics. As a result, cash and carry arbitrage is assessed within the broader context of market efficiency and derivatives pricing rather than as a guaranteed outcome.

This content is for informational purposes only and the same should not be construed as investment advice. Bajaj Finserv Direct Limited shall not be liable or responsible for any investment decision that you may take based on this content.