Reverse Cash and Carry arbitrage is a combination of short position in underlying asset (cash) and long position in underlying future. It is initiated when future is trading at a discount as compared to cash market price. In other words, the cash market price is trading higher as compared to future. The arbitrageur/ trader can take position by selling his delivery of stocks in cash and simultaneously buying futures of same underlying assets of equal quantity. A trader must have delivery in that particular stock when there is such an opportunity available in the market.
Reverse cash and carry arbitrage occurs when market is in “Backwardation”, which means future contracts are trading at a discount to the spot price.
Let’s try to understand with the help example of CEATLTD as on 26th APRIL 2017:
As we can see in the above illustration from 5paisa terminal there was a price difference between cash market price and May futures price of Rs 60.
Cash market price (as on 26th April 2017) (S) | Rs 1570 |
May Futures (Expiry on 29th May 2017) (F) | Rs 1510 |
Contract size | 700 |
Rate of Interest | 9% (p.a.) |
Time to expiry (n) | 29 days |
Amount received from selling Delivery of CEAT | Rs 10,99,000 (1570*700) |
Margin required to sell futures | Rs 1,37,595 |
Free cash available | Rs 9,61,405 |
Fair value is measured by the formula | S= F/(1+R)^n |
Lending rate | 0.72% |
Basis | Spot price-Future price |
Gain from amount lend is Rs 6,874.71 (9,61,405*(0.09^(29/365)))
S= 1510/(1+0.09)^(29/365)
Fair Value of spot price (S)= 1500
Current spot price= 1570
Hence, we can see that there is an arbitrage opportunity.
Risk free Arbitrage=Rs 70 (1570-1500)
To take advantage from this mispricing, trader/arbitrageur will buy futures at Rs 1510 and sell CEATLTD in cash market at Rs 1570. This would result in gross arbitrage profit of Rs 42,000 (60*700). And income received from lended amount would be Rs 6874.71, so Net arbitrage profit would be Rs 48,874.71.
Scenario analysis:
Case 1: CEATLTD rises to 1620, at expiry
Loss on underlying (cash) = (1620-1570)*700= (Rs 35,000)
Profit on futures = (1620-1510)*700= Rs 77,000
Gross Gain on Arbitrage= Rs 42,000
Inflow from lending: Rs 6874.71
Net gain from arbitrage: Rs 48,874.71
Case 2: CEATLTD falls to 1450, at expiry
Profit on underlying (cash) = (1570-1450)*700= Rs 84,000
Loss on Futures= (1510-1450)*700= (Rs 42,000)
Gross Gain on Arbitrage= Rs 42,000
Inflow from lending: Rs 6874.71
Net gain from arbitrage: Rs 48,874.71
To round up, in any reverse cash and carry arbitrage, the moment you trigger this arbitrage, your profit is fixed depending upon the arbitrage opportunity. This is also called risk free arbitrage because your profit is secured irrespective of underlying price movement.
Whenever future price of an underlying asset are higher than the current spot price, a cash and carry arbitrage opportunity arises.
