Reverse Cash And Carry Arbitrage

Key Takeaways

• Reverse cash-and-carry arbitrage involves shorting an asset's cash position while simultaneously taking a long position in its futures contract.
• The strategy aims to capitalize on the price difference between an asset's spot price and its futures price, mainly in backwardation conditions.
• This arbitrage generates profits when the futures price is lower than the spot price, covering short-selling expenses.
• Risks remain due to potential changes in carrying costs or broker margin rates, challenging the strategy's riskless nature.

What Is a Reverse Cash-and-Carry Arbitrage?

Reverse cash-and-carry arbitrage is a financial strategy used to take advantage of pricing inefficiencies between an asset's current cash (spot) price and its future price by simultaneously holding a short position in the asset and a long position in that asset's futures contract. This market-neutral strategy allows traders to potentially earn riskless profits by purchasing the futures contract at a lower price than the current asset price and covering the short position upon maturity. The success of reverse cash-and-carry arbitrage hinges on conditions where the futures price is lower than the spot price, primarily due to a market condition called backwardation.

How Reverse Cash-and-Carry Arbitrage Works

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 the asset will be delivered against the futures contract.

For a reverse cash-and-carry arbitrage, the arbitrageur holds a short position in the asset, commonly a stock or commodity, and a long position in that asset's futures contract.

At maturity, the arbitrageur 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 lower than 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.

A reverse cash-and-carry arbitrage 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, where futures contracts with later expiration dates, also known as back month contracts, trade at a discount to the spot price. The arbitrageur is betting that this condition, which is abnormal, will revert back to form, thus creating the environment for a riskless profit.

Example Illustration of Reverse 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 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 ($104 - $100 - $2).

The term riskless is not completely accurate as risk still exists, such as an increase in carrying costs, or 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 next step 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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