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 corresponding derivative. The key to profiting from this strategy is the eventual correction in that mispricing.
A cash-and-carry trade should not be confused with a carry trade in the context of forex trading; such a carry trade looks for interest rate differentials between countries.
- A cash-and-carry trade is an arbitrage strategy that profits off the mispricing between the underlying asset and its corresponding derivative.
- A cash-and-carry trade is usually executed by entering a long position in an asset while simultaneously selling the associated derivative.
- Specifically, this is done by going short the market via a futures or options contract.
Understanding Cash-and-Carry Trades
A cash-and-carry trade is a trading strategy that an investor can utilize in order to take advantage of market pricing discrepancies. It usually entails taking a long position in a security or commodity while simultaneously selling the associated derivative, specifically by shorting a futures or options contract.
The security or commodity being purchased is held until the contract delivery date and is used to cover the short position’s obligation. By selling a futures contract, the investor has taken a short position. The investor knows how much will be made on the delivery date and the cost of the security because of the cash-and-carry trade’s long position component.
For example, in the case of a bond, the investor receives the coupon payments from the bond they've bought, plus any investment income earned by investing the coupons, as well as the predetermined future price at the future delivery date.
How a Cash-and-Carry Trade Works
The concept behind a cash-and-carry trade is rather simple:
- An investor identifies two securities that are mispriced with respect to each other; for instance, the spot crude price and crude futures price, which presents an arbitrage opportunity.
- The investor must first purchase spot crude and sell a crude futures contract. Then, they hold (or "carry") spot crude until the crude futures contract expires, at which time the investor delivers the spot crude.
- Regardless of what the delivery price is, a profit is only assured if the purchase price of spot crude plus the cost of carry is less than the price at which the crude futures contract was initially sold.
Cash-and-Carry Trades in the Credit Derivatives Market
This strategy is commonly known as basis trading, Often, carry trades are executed in order to take advantage of the implied interest rates generated from the positions because they may end up being more favorable than borrowing or lending through traditional channels.
This strategy also has an application in the credit derivatives market, where basis (the difference between a commodity's immediate cash price and its futures price) represents the difference in spread between credit default swaps (CDS) and bonds for the same debt issuer (and with similar—if not exactly equal—maturities).
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 smaller than the bond spread.) The trade is usually done with bonds that are trading at par or at a discount, and a single-name CDS (as opposed to an index CDS) of a tenor equal to the maturity of the bond.
Cash-and-Carry Trades in the Options Market
In the options market, an example of a carry trade is a box spread. Box spreads are used for borrowing or lending at implied rates that are more favorable than a trader going to their prime broker, clearing firm, or bank. Because 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 price paid for today can be thought of as that of a zero-coupon bond. The lower the initial cost of the box, the higher its implied interest rate. This concept is known as a synthetic loan. Thus, the difference in the price of the box spread from the difference between the strike prices is the carry.
For instance, if a trader executes a carry trade using a box spread in the S&P 500 using 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 represents the implied interest rate associated with the cost of carry.
Example of a Cash-and-Carry Trade
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—for this asset is equal to $2. In this case, the trader would buy the asset (open a long position) at $100, and simultaneously sell the one-month futures contract (initiate a short position) at $104.
The cost to buy and hold the asset is $102, but the investor has already 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, thereby ensuring an arbitrage profit of $2.
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