Cash-and-Carry Trade

What is a cash-and-carry trade?

A cash-and-carry transaction is an arbitrage strategy that capitalizes on the mispricing between an asset and its corresponding derivative.

Profiting from this strategy necessitates the eventual correction of the mispricing.

In the context of forex trading, a cash-and-carry transaction should not be confounded with a carry trade, which is characterized by the search for interest rate differentials between countries.

• A cash-and-carry transaction is an arbitrage strategy that capitalizes on the mispricing between the underlying asset and its corresponding derivative.
• Typically, a cash-and-carry transaction involves the simultaneous sale of the associated derivative and the establishment of a long position in an asset.\
• This is accomplished by shorting the market through a futures or options contract.

Comprehending Cash-and-Carry Trades

A cash-and-carry trade capitalizes on market pricing discrepancies.

It typically involves purchasing a security or commodity and simultaneously selling the corresponding derivative, specifically by shorting a futures or options contract.

The security or commodity that is being acquired is retained until the delivery date of the contract and is utilized to satisfy the obligation of the short position.

The investor has entered into a short position by selling a futures contract.

The investor is aware of the cost of the security and the amount that will be earned on the delivery date as a result of the long position component of the cash-and-carry trade.

For instance, the investor acquires the coupon payments from the bond they purchased, as well as any investment income generated by the coupons, and the predetermined future price at the delivery date in the future.

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Procedures for a Cash-and-Carry Trade

In a cash-and-carry transaction, there are three primary steps:

• An investor recognizes two securities that are presently mispriced in relation to one another, such as the market crude price and crude futures price. This presents an arbitrage opportunity.
• The investor must initially acquire physical petroleum and dispose of a crude futures contract.
• Next, the investor is required to maintain (or “carry”) spot crude until the expiration of the petroleum futures contract.At that point, the investor is required to deliver the spot crude.

A profit is only guaranteed if the purchase price of spot petroleum plus the cost of carry is less than the price at which the crude futures contract was initially sold, irrespective of the delivery price.

Cash-and-Carry Trades in the Credit Derivatives Market

This strategy is frequently referred to as basis trading.

Carry trades are frequently executed to capitalize on the implicit interest rates generated by the positions, as they may prove to be more advantageous than borrowing or lending through conventional channels.

This strategy is also applicable in the credit derivatives market, where the basis (the difference between a commodity’s immediate cash price and its futures price) corresponds to the spread between credit default swaps (CDS) and bonds for the same debt issuer, with similar—if not identical—maturities.

The strategy is referred to as a negative basis trade in this context.

(In the credit derivatives market, the basis can be either positive or negative; a negative basis indicates that the CDS spread is less than the bond spread.)

The trade typically involves bonds that are trading at par or at a discount, as well as a single-name CDS (as opposed to an index CDS) with a tenor that is equivalent to the bond’s maturity.

Cash-and-Carry Trades in the Options Market

A box spread is an example of a carry trade in the options market.

Box spreads are employed to borrow or lend at implicit rates that are more favorable than those that a trader would receive from their prime broker, clearing firm, or bank.

The price paid today can be compared to that of a zero-coupon bond, as the price of a box at its expiration will always be the distance between the strikes involved (e.g., a 100-pt box might utilize the 25 and 125 strikes and would be worth $100 at expiration).

The implied interest rate of the box is higher as the initial cost decreases.

A synthetic loan is the term used to describe this concept. Consequently, the carry is the price differential in the box spread resulting from the difference between the strike prices.

For example, if a trader implements a carry trade in the S&P 500 using the 1,000 and 2,000 strikes, the spread will be valued at $1,000 at expiration (i.e., the distance between strikes).

The implied interest rate associated with the cost of carry is $50 if the spread costs $1,050 in the market.

An illustration of a cash-and-carry transaction

Assume that the one-month futures contract is priced at $104 and that an asset is currently trading at $100.

Furthermore, the monthly carrying costs of this asset, which include storage, insurance, and financing, are $2.

In this scenario, the trader would acquire the asset (open a long position) at $100 and concurrently sell the one-month futures contract (initiate a short position) at $104.

The investor has already secured a transaction at $104, despite the fact that the cost to acquire and maintain the asset is $102.

The asset would be carried by the speculator until the futures contract’s expiration date, at which point it would be delivered against the contract, thereby guaranteeing an arbitrage profit of $2.

Note
Tax, investment, and financial services and advice are not offered by Investopedia. The information is provided without regard for the financial circumstances, risk tolerance, or investment objectives of any particular investor and may not be appropriate for all investors. The potential loss of principal is a risk associated with investing.

Arbitrage: What is it?

Arbitrage is a strategy that involves the simultaneous purchase and sale of the same asset in various markets or derivative forms in order to capitalize on the temporary fluctuations in their pricing.

Arbitrage is employed in international stock markets, as well as in the currency and commodities markets.

Is an arbitrage trade equivalent to a cash-and-carry trade?

A cash-and-carry transaction is a form of arbitrage trading.

The trader capitalizes on the disparity in pricing between an asset and a derivative that is derived from it in this instance.

The trader capitalizes on the fleeting price differential by purchasing one and selling the other.

Is cash-and-carry permissible in the United States?

Arbitrage trading is generally permissible in the United States, as is the cash-and-carry trade.

In reality, the practice is actively promoted as a method of enhancing market efficacy and ensuring liquidity in the markets.

In conclusion,

The cash-and-carry transaction is a type of arbitrage, which involves the purchase and sale of the same asset in two markets to capitalize on the temporary price differences.

The currency markets are perhaps the most well-known example of the practice of arbitrage, as the strategy is facilitated by the minute discrepancies in posted prices.

However, cash-and-carry is contingent upon a distinct set of assets: one that is the “real” asset and another that is a derivative that is predicated on the price of the asset.

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