Reverse Cash-and-Carry Arbitrage

What Is a Reverse Cash-and-Carry Arbitrage?

Reverse cash-and-carry arbitrage is a market-neutral strategy joining a short position in an asset and a long futures position in that equivalent asset. Its goal is to take advantage of pricing shortcomings between that asset's cash, or spot, price and the relating future's price to produce riskless profits.

Understanding Reverse Cash-and-Carry Arbitrage

As its name proposes, reverse cash-and-carry arbitrage is the mirror picture of a normal cash-and-carry arbitrage. In the last option, the arbitrageur conveys the asset until the expiration date of the futures contract, at which point the asset will be delivered against the futures contract.

For a reverse cash-and-carry arbitrage, the arbitrageur stands firm on a short footing in the asset, generally a stock or commodity, and a long position in that asset's futures contract.

At maturity, the arbitrageur acknowledges delivery of the asset against the futures contract, which is utilized to cover the short position. This strategy is just practical assuming that the futures price is lower than the spot price of the asset. That is, the proceeds from the short sale ought to surpass the price of the futures contract and the costs associated with carrying the short position in the asset.

A reverse cash-and-carry arbitrage strategy is just beneficial in the event that the futures price is cheap comparative with the spot price of the asset. This is a condition known as backwardation, where futures contracts with later expiration dates, otherwise called back month contracts, trade at a discount to the spot price. The arbitrageur is betting that this condition, which is abnormal, will return to form, consequently establishing the environment for a riskless profit.

Illustration of Cash-and-Carry Arbitrage

Think about the accompanying illustration of a reverse cash-and-carry arbitrage. Accept an asset at present trades at $104, while the one-month futures contract is priced at $100. Also, month to month carrying costs on the short position (for instance, dividends are payable by the short seller) amount to $2. In this case, the arbitrageur would start a short position in the asset at $104, and at the same time buy the one-month futures contract at $100. Endless supply of the futures contract, the trader acknowledges delivery of the asset and utilizations it to cover the short position in the asset, subsequently guaranteeing an arbitrage, or riskless, profit of $2 ($104 - $100 - $2).

The term riskless isn't totally accurate as risk actually exists, for example, an increase in carrying costs, or the business firm raising its margin rates. In any case, the risk of any market movement, which is the major part in any customary long or short trade, is alleviated by the way that once the trade is set moving, the next step is the delivery of the asset against the futures contract. There is compelling reason need to access either side of the trade in the open market at expiration.

Features

• Reverse cash-and-carry arbitrage is a market-neutral strategy joining a short position in an asset and a long futures position in that equivalent asset.
• A reverse cash-and-carry arbitrage strategy is just beneficial in the event that the futures price is cheap comparative with the spot price of the asset.
• Reverse cash-and-carry arbitrage looks to take advantage of pricing shortcomings between that asset's cash price and the comparing futures price to produce riskless profits.