Meaning of Cash Future Arbitrage

Arbitrage is the use of different prices to leverage the differences in markets. Futures arbitrage refers to the leveraging of the price difference between an asset and its future contract. Every now and again, mispricing can occur in derivative instruments that are based on an underlying asset. Trader can spot mispricing with the right tools and techniques and profit from it. Cash future arbitrage is a common strategy for arbitrage. Cash future arbitrage refers to cash in cash, spot market.

If you're curious about cash future arbitrage, keep reading. This is the opportunity to use the difference in price between future cash and cash, especially at the beginning of each month. Basis is the difference between future price and cash. Both the spot and future prices will be similar as the expiration date nears. However, pricing is different in the time before expiration, or during arbitrage. If the basis of an asset is negative it means that the asset's price will rise in the future. Positive basis means that the cash or spot price is higher than the future price. This indicates a bear market in the future.

Cash to future arbitrage is a good option. You should closely monitor the basis to see if it is higher or lower than the cost of the trade. A futures contract with a later expiration date can be more uncertain because there are potential price fluctuations. Therefore, the basis may be higher. These futures could also be more expensive than the underlying asset. The basis falls over time until it reaches zero or close to zero. Finally, the expiration date is set.

Consider these points when looking at cash future arbitrage:

• Contango is a term that refers to futures trading at a premium (higher than the cash or spot market). The most common use of premium is in the equity derivatives market. Contango is more commonly used in commodity derivatives.
• Backwardation is when futures trade at a lower discount than the cash market. Backwardation is commonly used in commodity derivatives markets, but both discount or this term can be interchanged.
• If the discount is widening, it indicates a bearish market trend.
• If the premium rises, it indicates that there is a bullish marketplace in the future.

Cash futures arbitrage example

Consider stock X on January 1, 2020. Its cash market price for the stock is Rs 150, and its May futures price is Rs 152. The multiplier of the contract would be 100 shares. Imagine there is a cost to carry. This is 8% per annum or 0.75 percent per month. The fair price can be calculated by using the formula F = S*exp (rT), where S is the spot price, and r is the cost per month of carry. T is the time until expiration in years. In this example, 150*exp(0.0075*5/12) is the fair price. This gives us a number 150.469. This means it is an overvalued forwards contract (market price at Rs 152). You go long in cash and short in futures.

A trader would have 100 shares of the stock if the stock price rises to Rs 155. The profit would be between 155 and 150x100, or Rs 500. Futures would cost you Rs 300. The arbitrage costs the trader Rs 200. This arbitrage costs Rs 0.469 for 100 shares. Your total gain would be Rs 200-Rs 26.9. This would amount to Rs 153.1

If you consider that the Rs 150 stockX falls to Rs 148, it would be a different scenario. For 100 shares, this would mean that the loss on the underlying asset would amount to Rs 200. For 100 shares, the futures profit would be Rs 400 (152-148). Arbitrage would net you Rs 200. To reduce the cost of carry, you would need to subtract Rs 46.9 from Rs 200. This would give you Rs 153.1. This cash futures arbitrage example demonstrates the simplicity of the trading strategy.

Summarising

This cash futures arbitrage example demonstrates that futures offer traders the opportunity to leverage pricing differences and make a profit in a relatively riskless manner. The cash to future arbitrage strategy is simple.