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Definition: Cash and Carry Arbitrage
When an arbitrageur buys an underlying asset in a futures contract in the spot market and holds it till the expiration date of the futures contract, she is ‘carrying’ the asset to be delivered against the contract. To exploit the pricing inefficiencies in the asset market, the acquiring cost and holding (Carrying) cost must be less than the cash income from the short futures position.
The trader can make money while the implied rate is more than the current market interest rate for the duration of futures contract (thus, an arbitrage opportunity exists). Also applicable to forwards contracts. Reverse Cash and Carry Arbitrage is also possible. This can be done by assuming a short position in an asset and a long position in the futures of the same asset – works only when the returns from short position exceed the quoted price of futures contract and the holding costs of the short position.
For example: An asset trader buys an asset for Rs. 500 and holds it for a cost of Rs. 20 for a period of 6 months. If she can initiate a short position in the asset futures for Rs. 550, meaning she sells the 6-month futures contract for Rs. 550, she can deliver the asset after six months and earn a riskless profit of Rs. 30. This is cash and carry arbitrage assuming the trader is able to sell the futures contract at a premium to her carrying cost.