Cash and Carry
A cash-and-carry trade is an arbitrage approach that takes advantage of the mispriced underlying value and its derivative. The ultimate correction in that price difference is the cornerstone to earning from this method.
Meaning of Cash and Carry
Cash and carry is a specific arbitrage approach that makes the most of price gaps between an underlying asset and its derivative. The price correction is the basis of earning profits in this strategy.
Cash and Carry Definition
A cash-and-carry trade is an arbitrage method in which the underlying asset and its related derivative are mispriced. A cash-and-carry trade is one in which the trader takes a long position in an asset whereas concurrently selling the underlying derivative. It is achieved by selling a futures or options contract to short the market.
Traders employ this approach to profit on the spread between the underlying security's value and its related futures price. Until the purchase price combined with the cost of carrying is lower than the cash gained by selling the futures contract prior to its expiry, the trade will reap profits.
How Does Cash and Carry Work?
A cash-and-carry deal is based on a basic principle. An investor notices that two securities are overvalued or undervalued in relation to one another. It might, for example, be the difference between the current and futures price of crude oil, which creates an opportunity for profit.
First, the trader must buy spot crude and then sell a crude futures contract. The trader then holds or carries spot crude until the crude futures contract matures, at which point they transfer the spot crude.
A return is only guaranteed if the buying price of spot crude combined with the cost of carrying is not more than the cost at which the crude futures contract was originally sold, irrespective of the delivery price.
Examples of Cash and Carry
Assume a commodity is now trading at $100, and a one-month futures contract is holding steady at $104. On top of that, the asset's monthly carrying expenses, which include storing, insuring, and funding, are $2. The investor would purchase the asset for $100 and liquidate the one-month futures contract by opening a short position at $104 in this scenario.
The amount required to hold the asset is $102, but the trader has already agreed to sell it for $104. The trader would then instead hold the asset only until the futures contract's expiry date and afterward, deliver it in lieu of the contract. Consequently, an arbitrage return of $2 is guaranteed.
Cash and Carry in the Credit Derivatives Market
Cash-and-Carry Basis trade is a term used to describe trading in the Credit Derivatives Market. Carry trades are used to make the most of the implicit interest rates created by the positions, which could be more advantageous than lending via standard streams. This method is also used in the credit derivatives market, wherein basis refers to the spread difference between credit default swaps (CDS) and bonds issued by the very same debt provider. The approach is known as a negative basis trade in this case. The trade typically involves bonds that are trading at par or at a deficit, as well as a single-name CDS with a duration equivalent to the bond's expiry.
Cash and Carry in the Options Market
A box spread is a clear instance of carrying trade in the options market. Traders use box spreads to lend or loan at implicit rates that are lower than those offered by a trader's primary broker, clearing agency, or financial institution. The amount paid now can be viewed as a zero-coupon bond since the cost of a box upon its maturity will still be the gap between the strikes engaged. The greater the suggested interest rate, the lesser the box's original cost. 'Synthetic loan' is the term for this notion.
The spread will be worth $1,000 at maturity when a buyer makes a carry trade in the S&P 500 through a box spread with the 1,000 and 2,000 strikes. The implicit interest rate related to the cost of carrying is $60 if the spread costs $1,060 in the market.
Conclusion
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FAQ
What is a reverse cash-and-carry?
A balanced approach pairing a short position in an asset and a long futures position in the same asset is known as reverse cash-and-carry arbitrage. Its purpose is to earn risk-free profits by exploiting pricing discrepancies between that asset's cash or spot price and the associated futures price.
What is futures cash-and-carry?
By going long in the marketplace and short in the futures contract, cash-and-carry arbitrage seeks to maximize pricing discrepancies among spot and futures markets for an instrument. The goal is to "carry" the instrument for physical exchange until the futures contract expires.