Posted in Finance, Accounting and Economics Terms, Total Reads: 255
Definition: Cash and Carry Trade
Cash and Carry Trade which is also commonly referred to as basis trading is essentially an arbitrage opportunity exploited by going long (to buy, in financial parlance) on an asset which could be a stock, or a commodity and subsequently going short (in order to sell in the future) in a futures contract.
An arbitrage is a riskless way of making profit. An analogy to arbitrage, would be a Rs.100 note fallen on the street. Firstly, it happens rarely, and secondly, it is often picked up before you happen to see it i.e. the potential opportunity is wiped off by arbitrageurs, or in our analogy, onlookers who actively seek money fallen on the streets.
Let’s take an example to understand this situation.
Let’s say a kg of copper costs Rs.100 today (say 1-1-2015).
1. A futures contract of copper, with a strike price of Rs.120 is available dated (1-1-2016).
2. The interest rate for borrowing is 8%p.a.
3. Storage costs are Rs.5/kg/year.
If the following actions are taken –
1. Borrow Rs.1,00,000
2. Procure a short futures contract (to sell in future)
3. Buy 1,000 KGs of copper and store them for a year
4. Sell the copper as per futures contract after a year and close the debts
Let’s understand the computations –
1. You owe the bank – Rs. 1,08,000
2. You have spent for storage – Rs.5,000
3. You receive from delivering the copper – Rs.1,20,000
This gives you a risk free Rs.7,000 as profit. This scheme of trading is cash and carry trading creating a situation of arbitrage for an arbitrageur.