Reverse Cash and Carry Arbitrage & Example Best Answer 2021

There are many words in futures and option trading which looks difficult to understand but when you read about them, they are quite simple. One of them is Reverse Cash and Carry Arbitrage.

We will discuss definitions of it and related words to it with example. However, To discuss this technique, first we need to understand the arbitrage.

What is Arbitrage?

Arbitrage is an essential word in stock market. It relates to the steps of purchasing a stock or commodity in one segment and selling it in another at a better price at the same time.

Arbitrage is meaningful in the pricing of derivative segment such as options and futures. There are various arbitrage techniques, one of which is reverse cash and carry arbitrage.

Before jumping into the meaning of reverse cash and carry arbitrage, let’s understand cash and carry arbitrage.

What is Cash and Carry Arbitrage?

You may aware that the futures contract and the current market price will come at same price on the end of the futures expiry date, However, they are not traded at same price during the the days before expiry or on expiry.

When the cost of the future is significantly high than the cost of the current market price, or the basic asset, a trader should short the futures contract and long the current market price leading up to the expiry date.

This is known as cash and carry arbitrage. Now let’s Understand Reverse Cash and Carry Arbitrage.

What is Reverse Cash and Carry Arbitrage?

The flip side of cash and carry arbitrage is reverse cash and carry arbitrage. When the cost of the future is significantly lower than the cost of the current market price, or the basic asset, a trader should long the futures contract and short the current market price leading up to the expiry date.

It is an approach that combines an asset’s short and long futures positions. It allows a trader to get profit from the contradictory rates opportunity among cash and futures rates of the same asset underlying.

Instance of reverse cash and carry arbitrage

Here’s an illustration of a reverse carry arbitrage: An stock is currently trading at INR 205, although the one-month futures contract is trading at INR 200. Suppose that the costs of maintaining the short position price to INR 2.

As a result, a trader would open a short position at INR 205 and a futures position at INR 200. When the future contract matures, the trader accepts the asset delivery and uses it to protect the asset’s short position.

As an outcome of this, the trader earns INR 3 (205–200- 2 = 3)

Originally published at https://profitmust.com on May 9, 2021.