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 profitability is the eventual correction in that mispricing.
- A cash-and-carry trade is an arbitrage strategy that profits off the mispricing between the underlying asset and its corresponding derivative.
- Investors usually enters a long position in an asset while simultaneously selling the associated derivative, specifically by shorting a futures or options contract.
- A profit is assured if, and only 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.
Understanding Cash-And-Carry Trade
A cash-and-carry trade (sometimes referred to just as a "carry trade") is a trading strategy which an investor can utilize to take advantage of market pricing discrepancies. It usually entails 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, and 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 he has bought, plus any investment income earned by investing the coupons, as well as the predetermined future price at the future delivery date.
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 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 assured if, and only 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.
This strategy is commonly known as basis trading, Often, carry trades are implemented to take advantage of the implied interest rates generated from the positions that may end up being more favorable than borrowing or lending through traditional channels.
Cash-and-Carry Trade Example
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 $2. In this case, the trader or arbitrageur 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 or risk-less profit of $2.
Negative Basis Trade
This concept can be transferred to 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 Using Options
In the options market, an example of a carry trade is a box spread. Here, a trader shorts a synthetic underlying (selling the call and buying the put at the same expiration and strike) at one strike price and goes long a synthetic underlying at a higher strike price (or vice versa). 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 with the 1,000 and 2,000 strikes, if the spread costs $1,050, the $50 represents the interest rate associated with the cost of carry.