Using Cash and Carry Arbitrage in Stock Markets: A Practical Guide

Arbitrage is a strategy used in trading to take advantage of price variations for the same asset across different markets. Cash and carry arbitrage is a specific form that capitalises on price discrepancies between the spot market (cash market) and the futures market. It is often considered a relatively low-risk strategy used by investors and traders to lock in risk-free profits by simultaneously buying an asset and selling its futures contract.

Get a detailed explanation of cash and carry arbitrage, including how it works, how investors can execute it, illustrative examples, risks involved, and practical points to consider before applying this strategy.

Cash and carry arbitrage involves purchasing an underlying asset in the spot market and simultaneously selling a futures contract on that asset when the futures price is higher than the spot price plus the cost of carry. The cost of carry refers to the expenses related to holding the asset until the futures contract expires, such as financing charges, storage costs (if applicable), and dividends forgone.

This price difference creates an arbitrage opportunity to earn a profit that is effectively risk-free, provided the trades are executed correctly and market conditions hold. This strategy contrasts with reverse cash and carry arbitrage, which involves short selling the asset and buying futures when the futures price is lower than the spot price minus the cost of carry.

The fundamental mechanism of cash and carry arbitrage can be summarised as follows:

• Spot Purchase: The arbitrageur buys the asset in the spot market at the current market price. This locks in ownership needed to fulfil the futures contract later.

• Futures Sale: At the same time, they sell an equal quantity of futures contracts at a higher price, securing a risk-free spread.

• Carry Cost: Costs such as interest on borrowed funds, storage, or missed dividends are factored into the trade.

• Holding Period: The asset is held until the futures contract is close to expiry, ensuring the arbitrage position remains intact.

• Closing Position: Upon expiry, the asset is delivered against the futures contract, and profit is realised after adjusting for all costs.

The profit arises when the futures price exceeds the spot price plus the cost of carry. This relationship is essential for arbitrage to be feasible.

To clarify the process, here are the steps investors follow:

• Step 1: Identify Arbitrage Opportunity
  Compare the spot price (S) of the underlying asset with the futures price (F). If
  F > S + Cost of Carry, then an arbitrage opportunity exists.
  

• Step 2: Buy the Underlying Asset
  Purchase the asset in the spot market at price S.
  

• Step 3: Sell Futures Contract
  Enter a short position in the futures market, agreeing to sell the asset at price F on contract expiry.
  

• Step 4: Hold Asset and Manage Costs
  Hold the asset through the contract duration, accounting for financing charges, storage, and dividends.
  

• Step 5: Deliver Asset or Close Futures Position
  At expiry, deliver the asset to settle the futures contract or offset positions if physical delivery is not required.
  

Formula to calculate arbitrage profit:

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

If this profit is positive after transaction costs, the arbitrage is viable.

Consider the following example to understand practical application:

• Spot price of stock XYZ: ₹1,000
  

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

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

• Transaction costs (brokerage, taxes): ₹5
  

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

In this case, an arbitrageur buys stock XYZ at ₹1,000, sells futures at ₹1,050, holds for 3 months while accounting for ₹20 carry costs and ₹5 transaction costs, and earns ₹25 per share risk-free.

Carrying costs refer to the expenses incurred while holding a position in an asset until the futures contract expires. These may include interest on borrowed funds used to purchase the asset, storage charges (for commodities), and opportunity costs such as missed dividends. In cash and carry arbitrage, these costs are deducted from the price difference between the spot and futures markets to determine the actual profit.

Despite its risk-averse reputation, cash and carry arbitrage carries certain risks and limitations:

• Price Convergence Failure: The futures price may not converge to the spot price at expiry, leading to losses.
  

• Transaction Costs: Brokerage, taxes, and financing charges can erode profits.
  

• Liquidity Risks: Difficulty in executing trades due to low market liquidity.
  

• Regulatory and Operational Risks: Margin requirements, settlement issues, and changing regulations can affect execution.
  

• Timing Risks: Holding periods can vary; market conditions may change during this time.
  

These factors necessitate careful analysis and prudent execution.

Cash and carry arbitrage offers investors a structured approach to capitalising on price differences between spot and futures markets. While it is considered a low-risk strategy, it requires thorough understanding of market mechanics, associated costs, and risks. By carefully executing the steps and maintaining awareness of market dynamics, investors can exploit arbitrage opportunities effectively.

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.

• Securities and Exchange Board of India (SEBI): https://www.sebi.gov.in/
  

• National Stock Exchange of India (NSE): https://www.nseindia.com/
  

• Investopedia – Cash and Carry Arbitrage: https://www.investopedia.com/terms/c/cashandcarryarbitrage.asp
  

• Commodity Futures Trading Commission (CFTC): https://www.cftc.gov/
  

• Zerodha Varsity – Arbitrage Trading: https://zerodha.com/varsity/chapter/arbitrage-trading/