What is a Cash-And-Carry Trade
A cash-and-carry trade (sometimes referred to just as a "carry trade") is a trading strategy in which an investor holds a long position in a security or commodity while simultaneously selling it – specifically, by holding a short position in a futures contract or options contract on the same security or commodity. In a cash-and-carry trade, which is also known as "basis trading," the asset is held until the contract delivery date, and is used to cover the short position’s obligation. 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.
BREAKING DOWN Cash-And-Carry Trade
A cash-and-carry trade has several steps. The investor must first purchase a security or commodity. He or she then sells a futures contract for that same security or commodity. He holds or "carries" that security or commodity until the futures contract expires. When it does, the investor delivers the commodity or security he previously bought.
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.
Rationale for Cash-and-Carry Trade
Investors use this arbitrage strategy when the current cost of buying a security or commodity, plus its cost of carry, is less than how much the security or commodity can be sold for in the future. In other words, the investor believes the securities are mispriced at the present time, and that he can profit by their eventual correction.
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 (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 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. (For details, see Get Positive Results With Negative Basis Trades.)
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.