Everything on Reverse Cash & Carry Arbitrage

Arbitrage is a key term in trading. Arbitrage is the act of purchasing a security in one market and then selling it in another market at a higher price. Arbitrage is an important part of derivative securities pricing. This includes options and futures. There are many types of arbitrage strategies. One example is reverse cash-and-carry arbitrage.

It is important to first understand the basic idea behind derivatives/futures trade before you can learn the definition of reverse cash and carry arbitrage. The spot or underlying asset is the basis of a futures contract. The spot and futures contracts have the same pricing at expiration, but they are priced differently during the period leading up to expiration.

A trader might want to short the futures contract if the spot or underlying asset's price is higher than the spot. This is called cash and carry arbitrage. Reverse cash and carry arbitrage is the opposite.

Are you curious about the definition of reverse cash and carry arbitrage? This strategy combines an asset's futures and short positions. This is where a trader can benefit from the mispricing opportunity between futures and cash prices for the same asset underlying by simultaneously buying and selling securities in the spot market.

Carry and cash

Reverse carry arbitrage refers to the flipping of cash and carry arbitrage. Cash and carry arbitrage is where you purchase futures contracts assets in the spot market, and then carry them through the arbitrage period. The reverse carry arbitrage strategy involves buying the underlying security and selling it short. The security is bought because it is cheap and you sell it short because the price is too high. You then take the cash and make a futures trade on the security.

Reverse cash and carry arbitration and cash and hold arbitrage are largely determined by the price of the futures contract. Cash and carry arbitrage are possible when the futures contract's price is too high. If the future contract price is too high, the trader may reverse cash or carry arbitrage.

Contango is a term used to describe a situation in which the future price is higher that spot. In reverse carry arbitrage, you will see the term backwardation. If the spot price is higher than that of the future, the market is in normal or backwardation.

What causes backwardation?

One reason could be:

• The future demand for the asset underlying is decreasing. The future contract will also drop in demand if future demand falls. A low demand will result in fewer buyers and a lower price.
• A sudden drop in supply could cause a spike in spot prices.

Reverse cash and carry arbitrage

Let's take an example of reverse carry arbitrage. An asset trades at Rs 103 while its futures contract (one-month) is at Rs 110. Let's say that the costs of maintaining the short position are Rs 1. A trader would open a short position at Rs.103 and then buy futures at Rs 100. The trader would then take delivery of the asset and use it to cover the shortfall in the asset once the future contract matures. Arbitrage is where the trader earns Rs 103-Rs100-Rs 1 = Rs 2.

Futures mispricings

Mispricings could result from many factors. These could be due to differences in trading times, regulatory controls on some exchanges or demand-supply shocks within a country. Arbitrage is when the pricing difference leads to arbitrage. This is basically about making the best of the difference between an underlying asset's future price and its current price.

Summarising

Anyone who trades in futures and derivatives markets will need to know about arbitrage strategies. Reverse cash and carry arbitrage is when you short sell a high-priced security and use the proceeds to buy futures positions of the underlying security. This strategy is popular because it is simple and has low risks.