What Is a Cash and Carry Transaction?
A cash and carry transaction is a type of trade in the futures market that occurs when the price of an underlying asset is different than its corresponding derivative. Cash and carry transactions are considered arbitrage, and take place either with cash or on the spot market.
A cash and carry transaction 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. It is sometimes also known as basis trading.
- A cash and carry transaction occurs when the spot price of a commodity is trading below the futures contract price.
- Cash and carry transactions may present arbitrage opportunities across spot and futures markets in the same underlying commodity.
- This price difference is typically due to inefficiencies in the market, as opposed to outright pricing errors; most often, these inefficiencies are caught and quickly fixed.
Understanding a Cash and Carry Transaction
Cash and carry transactions are considered arbitrage deals because they take advantage of the different price points between similar stocks, commodities, and assets across varying markets and forms. This price difference is typically due to inefficiencies in the market, as opposed to pricing errors. An inefficient market, according to the efficient market hypothesis, is one in which an asset's market prices do not always accurately reflect its true value.
Most often these differences in prices are caught and quickly fixed. Cash and carry transactions may take place in any market where there is a physical delivery mechanism. Although this type of trading is thought to be practically risk-free, there are some instances where it is not profitable. There are certain factors that should be analyzed against the possible profits from the trade, including fees, carrying costs, and dividends due.
Example of a Cash and Carry Transaction
Assume the stock of LOL is trading at $40 a share on the stock exchange, but it lists at $50 a share on the futures exchange. A trader would need to buy the stock at $40 a share on the spot, and then short the futures price at $50 a share. The trader would hold their LOL shares until the expiration of the futures contract. At expiration, the underlying becomes deliverable on the short futures contract. Here the trader delivers the stock for $50 and realizes a $10 profit, or a 10% return, on the cash and carry trade (not including costs or fees).
Consider another example where the share of LOL is trading at $80 per share but is going for $100 per share on the futures market. Now, the profit margin has increased, and after the short of the futures at $100 there is a $20 profit (20% return) on the initial investment (ROI).
It is easy to see how manipulating the arbitrage transactions can return a significant gain with seemingly little risk. A trader may realize a profit with this type of trade, but it is increasingly hard to find these inefficiencies in the modern, automated transaction world.