What is Cash-and-Carry-Arbitrage
Cash-and-carry-arbitrage is a market neutral strategy combining the purchase of a long position in an asset such as a stock or commodity, and the sale (short) of a position in a futures contract on that same underlying asset. It seeks to exploit pricing inefficiencies for the asset in the cash (or spot) market and futures markets, in order to make riskless profits. The futures contract must be theoretically expensive relative to the underlying asset or the arbitrage will not be profitable.
BREAKING DOWN Cash-and-Carry-Arbitrage
The arbitrageur would typically seek to "carry" the asset until the expiration date of the futures contract, at which point it would be delivered against the futures contract. Therefore, this strategy is only viable if the cash inflow from the short futures position exceeds the acquisition cost and carrying costs on the long asset position.
Example of Cash-and-Carry Arbitrage
Consider the following example of cash-and-carry-arbitrage. Assume an asset currently trades at $100, while the one-month futures contract is priced at $104. In addition, monthly carrying costs such as storage, insurance, and financing costs for this asset amount to $3. In this case, the trader or arbitrageur would buy the asset (or open a long position in it) at $100, and simultaneously sell the one-month futures contract (i.e. initiate a short position in it) at $104. The trader would then hold or carry the asset until the expiration date of the futures contract and deliver the asset against the contract, thereby ensuring an arbitrage or riskless profit of $1.
The term "riskless" is not 100% correct as there are still risks that carrying costs can increase, such as a brokerage raising its margin rates. However, the risk of any market movement, which is the major component in any regular long or short trade, is mitigated by the fact that once the trade is set in motion the only event is the delivery of the asset against the futures contract. There is no need to access either one in the open market at expiration.
Physical assets such as barrels of oil or tons of grain require storage and insurance, but stock indexes, like the S&P 500, likely require only financing costs, such as margin. Therefore, arbitrage may be more profitable, all else held constant, in these non-physical markets. However, since the barriers to participate in arbitrage are much lower they allow more players to attempt such a trade. The result is more efficient pricing between spot and futures markets and lower spreads between the two. Lower spreads mean lower opportunities to profit.
Less active markets may still have arbitrage possibilities, as long as there is adequate liquidity on both sides of the game—spot and futures.