What Is Cash-and-Carry Arbitrage?
Understand how cash-and-carry arbitrage works, why futures premiums matter and how carrying costs affect the potential profit.
Cash-and-carry arbitrage seeks to profit from a gap between a commodity’s spot and futures prices. Traders buy the commodity and sell its futures contract when the futures premium is high enough to cover financing, storage, insurance, transportation, handling, and trading costs, leaving a positive net spread.
Cash-and-carry arbitrage is a strategy that seeks to profit from a pricing difference between a commodity's spot price and its futures price. The basic idea is to buy the commodity in the spot market and sell the corresponding futures contract when the futures price is higher.
However, the price gap alone does not determine the potential profit. The trader must account for financing, storage, insurance, transportation, handling, and trading costs during the holding period. This makes the cost of carry an important part of the strategy.
In this guide, we first explain arbitrage and cash-and-carry arbitrage, then show how the strategy works step by step.
What Is Arbitrage?
Arbitrage is a strategy that seeks to profit from price differences between related markets or instruments. In commodity markets, arbitrage can occur when the same commodity has different prices in the spot and futures markets.
For example, suppose silver trades at ₹90,000 in the spot market, while its futures contract trades at ₹92,000. The ₹2,000 difference creates a potential arbitrage opportunity.
However, the price difference alone does not guarantee a profit. The trader must compare the futures premium with the costs involved in carrying the commodity until the futures contract expires.
What Is Cash-and-Carry Arbitrage?
Cash-and-carry arbitrage involves buying a commodity in the spot market and simultaneously selling its corresponding futures contract.
Its structure is: Buy the commodity in the spot market + Sell the commodity futures contract
The trader purchases the physical commodity and carries it until the futures position is closed or settled. The strategy works because the trader locks in a futures selling price while acquiring the commodity at the current spot price.
Suppose silver trades at ₹90,000 in the spot market and its futures contract trades at ₹92,000. The trader could:
- Buy silver at ₹90,000.
- Sell the silver futures contract at ₹92,000.
- Hold the silver during the relevant period.
- Deliver or otherwise settle the position according to the contract's specifications.
The initial price difference is ₹2,000. However, the ₹2,000 represents the gross spread.
The actual arbitrage return depends on the cost of carrying silver during the holding period.
SEBI explains that when a commodity futures contract trades significantly above the spot price and cost of carry, traders can potentially buy the underlying commodity and sell the futures contract.
How Does Cash-and-Carry Arbitrage Work?
The strategy generally involves four key steps.
Step 1: Identify a Futures Premium
The trader compares the spot price with the futures price. Suppose:
- Spot silver price = ₹90,000
- Silver futures price = ₹92,500
The futures premium is ₹2,500. The trader then estimates the total cost of carrying silver until the relevant futures settlement or delivery period.
Step 2: Buy the Commodity
The trader purchases the physical commodity at the spot price. In this example, the trader buys silver for ₹90,000.
Step 3: Sell the Futures Contract
The trader simultaneously sells the corresponding silver futures contract at ₹92,500. It locks in the futures selling price. The trader is therefore not relying on silver prices rising.
Step 4: Carry and Settle
The trader holds the commodity and manages the position until the futures contract approaches expiry or delivery. Depending on the contract's settlement mechanism, the trader may deliver the commodity or close the positions through the applicable settlement process.
The economic objective remains the same. The trader wants the futures premium to cover the costs of purchasing and carrying the commodity and leave a positive net spread.
In cash-and-carry arbitrage, what does the trader typically do when the futures price is sufficiently above the spot price?
What Costs are Involved in Cash-and-Carry Arbitrage?
The futures premium must cover the costs of holding the commodity. Key costs include:
- Financing costs: Interest paid on the money used to purchase the commodity until settlement.
- Storage costs: Charges for safely storing the physical commodity during the holding period.
- Insurance costs: Premiums that protect the commodity against theft, damage, or other covered risks.
- Transportation costs: Expenses for moving the commodity to the required storage or delivery location.
- Handling costs: Charges for loading, unloading, weighing, testing, or maintaining the commodity.
- Trading costs: Brokerage, exchange fees, taxes, and other transaction-related expenses.
Cash-and-Carry Arbitrage Example Using Silver
Consider a simplified example involving silver. Suppose:
- Spot silver price: ₹90,000
- Silver futures price: ₹92,500
- Financing cost: ₹800
- Storage and insurance: ₹500
- Other carrying expenses: ₹300
The gross futures premium is: ₹92,500 − ₹90,000 = ₹2,500
The estimated carrying cost is: ₹800 + ₹500 + ₹300 = ₹1,600
Therefore, potential net spread = ₹2,500 − ₹1,600 = ₹900
The trader could potentially earn ₹900 per equivalent unit before applicable taxes and transaction costs, assuming the trade executes as planned and the relevant settlement conditions are satisfied.
This example also shows why a futures premium alone does not establish an arbitrage opportunity.
If the carrying cost had been ₹2,700 instead, the same ₹2,500 futures premium would not have provided a positive spread.
Cash-and-Carry Arbitrage vs Reverse Cash-and-Carry Arbitrage
These two strategies use opposite positions.
| Strategy | Spot Market | Futures Market | Typical Pricing Situation |
|---|---|---|---|
| Cash-and-carry arbitrage | Buy commodity | Sell futures | Futures above spot and carrying cost |
| Reverse cash-and-carry | short commodity | Buy futures | Futures below spot |
Cash-and-carry arbitrage seeks to exploit an excessive futures premium.
Reverse cash-and-carry arbitrage seeks to exploit an excessive futures discount.
The difference becomes particularly important in commodity markets because shorting or sourcing the physical commodity can involve additional practical constraints.
READ MORE: What is a Quote-Driven Market?
When Is Cash-and-Carry Arbitrage Profitable?
A cash-and-carry trade becomes attractive when the futures premium is high enough to cover the total cost of acquiring and carrying the commodity.
A simplified formula is: Net Arbitrage Spread = Futures Price − Spot Price − Total Carrying Costs − Trading Costs
For example:
- Futures premium = ₹2,500
- Total carrying costs = ₹1,600
- Trading and other costs = ₹300
Therefore, Net spread = ₹2,500 − ₹1,600 − ₹300 = ₹600
The ₹600 represents the estimated net spread before any additional applicable costs or taxes not included in the calculation. This is why professional arbitrage traders focus on the net spread, rather than the headline difference between spot and futures prices.
Final Words
Cash-and-carry arbitrage offers a structured approach to benefit from pricing differences between spot and futures markets. As discussed, the strategy involves buying the commodity and selling its futures contract when the futures premium exceeds the total carrying costs.
However, the price difference alone does not guarantee a profit. Financing, storage, insurance, transportation, and trading costs can reduce the final return. Therefore, traders must calculate the net spread before entering a position.
By understanding these costs and the relationship between spot and futures prices, traders can better assess whether a potential cash-and-carry arbitrage opportunity is genuinely profitable.
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