Key Takeaways
- A cash-and-carry trade is an arbitrage strategy that profits by exploiting price discrepancies between an asset and its derivative.
- This strategy involves buying the underlying asset and simultaneously shorting its derivative to secure gains.
- A cash-and-carry trade is successful when the cost of purchasing and holding the asset is less than the derivative’s price.
- The strategy applies across markets like credit derivatives and options, offering advantageous implied interest rates.
- Market efficiency and liquidity benefit from legal cash-and-carry trades despite their inherent risks.
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What Is a Cash-and-Carry Trade?
A cash-and-carry trade occurs when an investor buys an asset in the spot market and sells a related futures contract on the same asset at the same time. This arbitrage strategy takes advantage of price differences between the two markets to earn a risk-free or low-risk profit. It works best when there’s mispricing between the spot and futures price. For example, a trader may buy a stock, hold it, and sell a futures contract at a higher price, taking the difference as profit when the contract expires.
The Mechanics of Cash-and-Carry Trades
A cash-and-carry trade takes advantage of market pricing discrepancies. It 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.
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. The investor 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 they’ve bought, plus any investment income earned by investing the coupons, as well as the predetermined future price at the future delivery date.
How to Execute a Cash-and-Carry Trade
There are three main steps in a cash-and-carry trade:
- An investor spots two mispriced securities, like spot crude and crude futures, creating an arbitrage chance.
- First, the investor buys spot crude and sells a crude futures contract.
- The investor holds the spot crude until the futures contract expires and then delivers it.
Regardless of what the delivery price is, a profit is only assured 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.
Using Cash-and-Carry Strategies in Credit Derivatives
This strategy is commonly known as basis trading. These trades often leverage implied interest rates, which can be better than traditional borrowing or lending.
This strategy also has an application in 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, it’s called a negative basis trade. A negative basis means 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.
Implementing Cash-and-Carry Strategies in Options Trading
In the options market, an example of a carry trade is a box spread.
Box spreads are used for borrowing or lending at implied rates that are more favorable than a trader going to their prime broker, clearing firm, or bank. Because the price of a box at its expiration will always be the distance between the strikes involved (e.g., a 100-pt box might utilize the 25 and 125 strikes and would be worth $100 at expiration), the price paid for today can be thought of as that of a zero-coupon bond.
The lower the initial cost of the box, the higher its implied interest rate.
This concept is known as a synthetic loan. Thus, 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 using the 1,000 and 2,000 strikes, the spread will be worth $1,000 at expiration (i.e., the distance between strikes). If the spread costs $1,050 in the market, that $50 represents the implied interest rate associated with the cost of carry.
Real-World Example of a Cash-and-Carry Trade
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—for this asset is equal to $2. In this case, the trader would buy the asset (open a long position) at $100, and simultaneously sell the one-month futures contract (initiate a short position) at $104.
Buying and holding the asset costs $102, but it’s sold for $104, locking in a $2 profit. The trader holds the asset until the futures contract expires and then delivers it.
What Is Arbitrage?
Arbitrage is simultaneously buying and selling the same asset in different markets or in derivative forms to profit from the brief differences in their prices.
Arbitrage is used in the currency and commodities markets as well as in international stock markets.
Is a Cash-and-Carry Trade the Same As an Arbitrage Trade?
A cash-and-carry trade is one type of arbitrage trade. In this case, the trader exploits the difference in pricing between an asset and a derivative that is based on that asset. The trader simultaneously buys one and sells the other, profiting from the brief difference in price.
Is Cash-and-Carry Legal in the U.S.?
The cash-and-carry trade is legal in the U.S., as is arbitrage trading in general. In fact, the practice is positively encouraged as a means of increasing market efficiency and providing liquidity in the markets.
The Bottom Line
The cash-and-carry trade is an arbitrage strategy that takes advantage of the price gap between an asset and its derivative by going long on the asset and shorting the derivative. A typical trade involves three steps: buying the asset, shorting the related derivative, and closing both positions when prices converge.
This strategy is widely used across commodities, credit derivatives, and options. Examples include basis trading and boz spreads. Legal and encouraged for improving market efficiency and liquidity, cash-and-carry trades still carry risks, so understanding the cost of carry is essential for profitability.
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