What is 'Reverse Cash-and-Carry Arbitrage'

Reverse cash-and-carry arbitrage is a market neutral strategy combining a short position in an asset, such as a stock or commodity, and a long position in the futures for that asset. Its goal is to exploit pricing inefficiencies for the same asset in the cash (or spot) and futures markets in order to make riskless profits.

The arbitrageur or trader accepts delivery of the asset against the futures contract, which is used to cover the short position. This strategy is only viable if the futures price is cheap in relation to the spot price of the asset. That is, the proceeds from the short sale should exceed the price of the futures contract and the costs associated with carrying the short position in the asset.

BREAKING DOWN 'Reverse Cash-and-Carry Arbitrage'

As its name suggests, reverse cash-and-carry arbitrage is the mirror image of a regular cash-and-carry arbitrage. In the latter, the arbitrageur "carries" the asset until the expiration date of the futures contract, at which point he or she delivers it against the futures contract. For a reverse arbitrage, the arbitrageur holds a short position in the asset and a long position in futures. At maturity, he or she accepts delivery of the asset to cover the short position.

The reverse strategy is only worthwhile if the futures price is cheap relative to the spot price of the asset. This is a condition known as backwardation, which simply means future contracts, also known as the back contracts, trade at a discount to the spot price.

Example of Cash-and-Carry Arbitrage

Consider the following example of a reverse cash-and-carry-arbitrage. Assume an asset currently trades at $104, while the one-month futures contract is priced at $100. In addition, monthly carrying costs on the short position (for example, dividends are payable by the short seller) amount to $2. In this case, the trader or arbitrageur would initiate a short position in the asset at $104, and simultaneously buy the one-month futures contract at $100. Upon maturity of the futures contract, the trader accepts delivery of the asset and uses it to cover the short position in the asset, thereby ensuring an arbitrage or riskless profit of $2.

The term "riskless" is not 100% correct as there are still risks that carrying costs can increase, such as the brokerage firm raising its margin rates. However, the risk of any market movement, which is the major component in any regular long or short trade, is mitigated by the fact that once the trade is set in motion, the only event is the delivery of the asset against the futures contract. There is no need to access either side of the trade in the open market at expiration.

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