Today we are talking about a type of arbitrage.
Arbitrage is an important term when it comes to trading. It is the process of buying a particular security in one market and selling it in another market at the same time, but at a higher price. Arbitrage plays a key role in derivative securities pricing, for example in options and futures.
Over the years, many different types of arbitrage strategies have developed. But the one we are discussing today is Reverse Cash And Carry Arbitrage.
Are you confused yet?
Let’s roll back a little bit before talking about the definitions. It will help us better to first understand the fundamental idea behind derivatives and futures trade.
A futures contract is based on an underlying asset or spot. Even though the futures contract and the spot are priced the same on the expiration date of the future, they are not priced similarly during the time period leading up to this expiration date.
So now when the price of the future is higher than the spot, traders would want to short the futures contract and long the spot that leads up to the expiration date. This is known as Cash And Carry Arbitrage.
The opposite of this is Reverse Cash And Carry Arbitrage. Wondering how that works?
It is essentially a strategy in which an asset’s short and long futures positions are combined. The mechanism is that the simultaneous purchase and sale of securities in the spot and future markets creates a chance of mispricing between cash and futures prices of the same underlying asset. And a trader can benefit from it.
You may also come across the term ‘backwardation’ while reading about reverse carry arbitrage. It refers to the state of a market when the price of the future is lower than the price of the spot.
Now you might wonder under what circumstances backwardation could occur.
There can be a few different reasons, such as, there could be a falling future demand for the underlying asset. When future demand goes down, the demand for the future contract also drops. This low demand would mean fewer buyers and lower price.
Or, there could be a sudden drop in the supplies of the asset, which would mean higher current price of the spot.
Let’s go on and compare the two mirroring strategies.
The reverse carry arbitrage is cash and carry arbitrage, but flipped. In cash and carry, one purchases the futures contract asset in the spot market, and carries it through the arbitrage period. In the reverse carry arbitrage strategy, one purchases the underlying security and sells it short. You purchase the security as it is underpriced and sell it short as it is overpriced. You can then take the cash and also take a futures position with regards to the security.
Now, the key difference between the two is owed to the pricing of the futures contract.
When the futures contract is overpriced, there is cash and carry arbitrage.
But if the future contract is underpriced, then the trader will employ reverse cash and carry arbitrage.
When the future price is higher than spot price, the situation is known as ‘contango’. Sounds just like the dance, doesn't it?
Let us go on and study an example where the reverse cash and carry arbitrage strategy is at play. It might help us understand better.
Let’s take the instance where Jiya, a seasoned investor, was interested in an asset. It was trading on the market at Rs 1500, while its futures contract (of one month) was at Rs 1000.
Jiya understood that there are some costs to carrying on the short position. For her it amounted to Rs 150. So what she did was initiate her short position at Rs 1500 while also buying the future at Rs 1000. After a month, her future contract matured. So Jiya took the asset delivery of Rs 1000 and used it to cover 1500, the short price in the asset. This is basically arbitrage as Jiya made Rs 1500 minus Rs 1000 minus Rs 150 (which were carrying costs) equals to Rs 350.
I’m sure you’re now wondering about these mispricings in futures.
Again, there could be several reasons. Some of the common ones are differences in trading times, varying regulatory controls across different exchanges and demand-supply shocks in certain countries. The pricing difference leads to arbitrage, which is all about making the most of the difference between the current price of an asset and its future contract.
In conclusion, arbitrage strategies are important if you want to trade in the futures or derivatives markets. With reverse cash and carry arbitrage, you sell an overpriced security short and use the proceeds to go long on a futures position of the same underlying security. The simplicity and the relatively low risk is what makes this strategy so popular,