If you have ever dealt with futures contracts, you have probably observed that the prices at which they trade are typically somewhat different from those at which they trade on spot markets. Although it is conceivable for the futures price to trade at a price that is lower than the spot price, which is also known as backwardation, it is significantly more typical for the futures price to trade at a price that is higher than the spot price (also known as contango).

When the market is in contango, a trader can collect this premium on the futures contract by carrying out cash and carry transactions. This premium is the difference between the current price and the future price. In cash and carry trade, the trader will first buy in the spot market of the underlying asset (for example, bitcoin).

After that, they will sell short the same asset by utilizing a dated futures contract that is now fetching a premium in the market. Because of this related short position, there is no risk associated with changes in the value of the underlying asset. At that moment, the only thing left for the trader is to keep calm and wait for the spread between the spot price and the futures price to get smaller.

What is a Cash-and-Carry Trade?

One sort of arbitrage method is known as the cash and carry trade. To complete the transaction, the cash and carry trade requires utilizing two distinct aspects of the trade. During a short transaction, security will essentially be purchased, and the asset underlying the security will be sold.

Both of these actions will take place simultaneously. In other situations, cash and carry trade will involve purchasing security and immediately selling another security identical to the one purchased.

Trading on the basis, also known simply as basis trading, is another name occasionally used to refer to cash and carry trades. It's not unusual for a deal to include futures since it's common practice to sell a component after buying a similar item.

A share of stock, a commodity, or an index could be the security purchased as part of the strategy. Conversely, a futures contract is typically utilized for the sale, culminating in completing the arbitrage technique.

How Does A Cash-And-Carry Trade Work?

A cash-and-carry arbitrage technique is implemented when a trader spots a profitable arbitrage opportunity. These investors seek out and put money into asset classes that they believe are undervalued relative to one another.

The investor decides to buy more of a particular commodity while simultaneously selling off the related financial derivative. The item purchased is stored until the delivery date specified in the associated contract expires. There is no risk to the trader's capital and immediate reward once the underlying is delivered against the contract.

The trader's gain is calculated as the difference between the underlying's purchase price and its entire carrying cost. When an investor shorts a contract, they are committing to sell the underlying asset at its current market price. Therefore, the investor will have set the asking price ahead of time.

This discrepancy between prices allows the trader to generate a risk-free profit if the underlying purchase price and its carrying cost are less than the price at which the contract is sold.

The Cash And Carry Trade Strategy

The cash and carry trade technique aims to generate income from the spread or mispricing between the asset class and its future derivative. It is the fundamental concept that underpins the cash and carries trade strategy.

The basis trade is also known as the cash and carry trade. The basis refers to the difference in price between the present value of an asset and the price at which its futures contract is now trading. The cash and carry trade allows traders to profit on the price gap that exists between the spot price of an asset and the price of its future derivative.

As a result of holding a long position, the investor is often aware of the amount of profit that can be made on the delivery date and the cost of the security or asset. It increases the likelihood that the investor will make a profit from the cash-and-carry deal. However, the amount of profit that can be made will be determined by the gap in price between the underlying asset and the futures contract on which it is based.

Trading Credit Derivatives with a Cash and Carry Aspect

The term basis trading is widely used to refer to this trading strategy. A common motivation for carrying trades is the opportunity to gain an advantage in implied interest rates. These rates may be better than what one could get by borrowing or lending via more traditional means. The credit derivatives market also uses this strategy, with the foundation being spread across credit default swaps and bonds from the same debt issuer.

The basis is calculated by subtracting the immediate cash price of a commodity from its futures price. A negative basis trade is a name given to this particular trading method. (In the credit derivatives market, the basis can be either positive or negative; a negative basis indicates that the CDS spread is narrower than the bond spread.) The trade is typically conducted with bonds trading at par or a discount and a single-name CDS of a tenor equal to the bond's maturity.

Conclusion:

The purchase price of the underlying item is known for a fact when using the cash and carry arbitrage strategy, but there is no way to predict the carrying costs. If the carrying costs of the underlying asset increase and climb to a level higher than the fixed sale price of the associated contract, the investor will suffer a loss rather than a profit.