What is a Cash and Carry Transaction
A cash and carry transaction is a type of trade in the futures market where the price of a commodity is below the futures contract price. Cash and carry transactions are considered arbitrage, and take place either with cash or on the spot market. It is sometimes also known as basis trading.
BREAKING DOWN Cash and Carry Transaction
Cash and carry transactions are 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. Consideration of factors such as fees, carrying costs, and dividends due which need to be analyzed against the possible profits from the trade.
Example of a Cash and Carry Transaction
Assume the stock of LOL is trading at $40 a share on the stock exchange but 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-percent 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, or 20-percent, 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.