Arbitrage is a key term used in trading. It refers to the process of buying a security in one specific market and selling it in another at the same time at a price that’s higher. Arbitrage plays an important role in derivative securities pricing, for instance in options and futures. There are different types of arbitrage strategies, and one among them is reverse cash and carry arbitrage.
Before learning the reverse cash and carry arbitrage definition, it helps to understand the fundamental idea behind the derivatives/futures trade. A futures contract is based on the underlying asset or spot. Although the futures contract and the spot have the same pricing on the expiration date of the future, they are not priced similarly during the time that leads up to the date of expiration.
When the price of the future is higher than that of the spot, or the underlying asset, a trader would want to short the futures contract and long the spot that leads up to the date of the expiration. This is cash and carry arbitrage. The opposite is reverse cash and carry arbitrage.
Wondering about reverse cash and carry arbitrage definition? It is a strategy wherein an asset’s short and long futures positions are combined. It is a mechanism wherein the sale and buying of securities in the spot and future markets simultaneously helps a trader benefit from the mispricing chance between cash and futures prices of the same asset underlying.
Cash and carry vs reverse cash and carry
The reverse carry arbitrage is the flip of cash and carry arbitrage. In cash and carry arbitrage, you buy the futures contract asset in the spot market and carry it through the arbitrage period. In the reverse carry arbitrage strategy, you buy the underlying security and sell it short. You buy the security because it is underpriced and sell it short because it is overpriced. Then you take the cash and take a futures position on the security.
The key difference between reverse cash and carry arbitrage and cash and carry arbitrage occurs owing to the pricing of the futures contract. When the futures contract is overpriced, there is cash and carry arbitrage. If the future contract is underpriced, then the trader will take to reverse cash and carry arbitrage.
The term that is used to refer to the situation wherein the future price is higher than spot is contango. You will come across the term backwardation in connection with reverse carry arbitrage. The market is said to be in backwardation or normal backwardation when the price of the future is lower than the price of the spot.
Why does backwardation occur?
Some of the reasons could be:
- There is a falling future demand for the asset underlying. When future demand comes down, the future contract also drops in demand. This low demand would mean fewer buyers and lower price.
- There could also be a drop in the supply of the asset suddenly, which could lead to a rise in current price of the spot.
Example of reverse cash and carry arbitrage
Here’s an example of a reverse carry arbitrage: An asset is trading at Rs 103, while its futures contract (one month) is at Rs 100. Let’s assume that there are costs of carrying on the short position amounting to Rs 1. So, a trader would initiate the short position at Rs 103 and also buy the future at Rs 100. Once the future contract matures, the trader takes the asset delivery and makes use of the same to cover the short in the asset. This results in arbitrage wherein the trader makes Rs 103-Rs 100-Rs 1 = Rs 2.
There could be several reasons for mispricings. They include differences in trading times, regulatory controls in some exchanges and demand-supply shocks in a certain country. The pricing difference is what leads to arbitrage, which is essentially all about making the most of the difference between the price of an underlying asset and its future contract.
Arbitrage strategies are important for anyone who wants to trade in the futures or derivatives markets. The reverse cash and carry arbitrage definition has it that you sell an overpriced security short, use the proceeds to go long on a futures position of the underlying security. The strategy is useful because of its simplicity and the relatively low risks involved, which is why it is used often.