Cash-and-Carry Trade

What Is a Cash-and-Carry Trade?

A cash-and-carry trade is an arbitrage strategy that exploits the mispricing between the underlying asset and its relating derivative. The key to profiting from this strategy is the possible correction in that mispricing.

A cash-and-carry trade ought not be mistaken for a carry trade with regards to forex trading; such a carry trade searches for interest rate differentials between countries.

Understanding Cash-and-Carry Trades

A cash-and-carry trade is a trading strategy that an investor can use to exploit market pricing errors. It typically involves taking a long position in a security or commodity while at the same time selling the associated derivative, explicitly by shorting a futures or options contract.

The security or commodity being purchased is held until the contract delivery date and is utilized to cover the short position's obligation. By selling a futures contract, the investor has taken a short position. The investor realizes how much will be made on the delivery date and the cost of the security in light of the cash-and-carry trade's long position part.

For instance, on account of a bond, the investor gets the coupon payments from the bond they've bought, plus any investment income earned by investing the coupons, as well as the foreordained future price at the future delivery date.

How a Cash-and-Carry Trade Works

The concept behind a cash-and-carry trade is fairly simple:

• An investor distinguishes two securities that are mispriced with respect to one another; for example, the spot crude price and crude futures price, which presents a arbitrage opportunity.
• The investor must initially purchase spot crude and sell a crude futures contract. Then, they hold (or "carry") spot crude until the crude futures contract terminates, when the investor delivers the spot crude.
• Despite what the delivery price is, a profit is possibly guaranteed on the off chance that the purchase price of spot crude plus the cost of carry is not exactly the price at which the crude futures contract was initially sold.

Cash-and-Carry Trades in the Credit Derivatives Market

This strategy is normally known as basis trading, Often, carry trades are executed to exploit the implied interest rates generated from the positions since they might turn out to be more good than borrowing or lending through traditional channels.

This strategy likewise has an application in the credit derivatives market, where basis (the difference between a commodity's immediate cash price and its futures price) addresses the difference in spread between credit default swaps (CDS) and bonds for a similar debt issuer (and with comparable — while possibly not precisely equivalent — developments).

Here, the strategy is called a negative basis trade. (In the credit derivatives market, basis can be positive or negative; a negative basis means that the CDS spread is more modest than the bond spread.) The trade is normally finished with bonds that are trading at par or at a discount, and a solitary name CDS (instead of a index CDS) of a tenor equivalent to the maturity of the bond.

Cash-and-Carry Trades in the Options Market

In the options market, an illustration of a carry trade is a box spread. Box spreads are utilized for borrowing or lending at implied rates that are more great than a trader going to their prime broker, clearing firm, or bank. Since the price of a crate at its expiration will constantly be the distance between the strikes in question (e.g., a 100-pt box could use the 25 and 125 strikes and would be worth $100 at expiration), the price paid for now can be considered that of a zero-coupon bond. The lower the initial cost of the crate, the higher its implied interest rate. This concept is known as a synthetic loan. Hence, the difference in the price of the container spread from the difference between the strike prices is the carry.

For example, on the off chance that a trader executes a carry trade utilizing a crate spread in the S&P 500 utilizing the 1,000 and 2,000 strikes, the spread will be worth $1,000 at expiration (i.e., the distance between strikes). If the spread costs $1,050 in the market, that $50 addresses the implied interest rate associated with the cost of carry.

Illustration of a Cash-and-Carry Trade

Accept an asset as of now trades at $100 while the one-month futures contract is priced at $104. Also, month to month carrying costs — like storage, insurance, and supporting — for this asset is equivalent to $2. In this case, the trader would buy the asset (open a long position) at $100, and all the while sell the one-month futures contract (start a short position) at $104.

The cost to buy and hold the asset is $102, yet the investor has proactively locked in a sale at $104. The trader would then carry the asset until the expiration date of the futures contract and deliver it against the contract, subsequently guaranteeing an arbitrage profit of $2.

Features

• A cash-and-carry trade is an arbitrage strategy that profits off the mispricing between the underlying asset and its relating derivative.
• A cash-and-carry trade is generally executed by entering a long position in an asset while at the same time selling the associated derivative.
• In particular, this is finished by going short the market through a futures or options contract.