Cash and carry arbitrage refers to a long position in the cash or underlying market and a short position in futures market.
The objective of arbitragers is to make profits without taking risk, but the complexity of activity is such that it may result in losses as well.
If futures price is higher than fair/theoretical price, there would exist profitable, riskfree, cash and carry arbitrage opportunity.
Arbitrage is simultaneous purchase and sale of an asset or replicating asset in the market in an attempt to profit from discrepancies in their prices.
Important point to understand is that in an efficient market, arbitrage opportunities may exist only for shorter period or none at all.
Practically, an arbitrage is feasible and will be undertaken only if it provides net cash inflow after transaction costs, brokerage, margin deposits etc.
Why does this have to be the futures price? If the futures price were greater than $0.65625, say $0.67, an investor could take advantage of the mispricing by selling the futures contract, completely hedging against risk and ending up with a return greater than the riskfree rate. The actions the investor would need to take are summarized in Table 11.1, with the cash flows associated with each action in brackets next to the action.
This arbitrage is based upon several assumptions. First, investors are assumed to borrow and lend at the same rate, which is the riskless rate. Second, when the futures contract is over priced, it is assumed that the seller of the futures contract (the arbitrageur) can sell short on the commodity and that he can recover, from the owner of the commodity, the storage costs that are saved as a consequence. To the extent that these assumptions are unrealistic, the bounds on prices within which arbitrage is not feasible expand. Assume, for instance, that the rate of borrowing is r b and the rate of lending is r a, and that short seller cannot recover any of the saved storage costs and has to pay a transactions cost of t s. The futures price will then fall within a bound.
In a currency futures contract, you enter into a contract to buy a foreign currency at a price fixed today. To see how spot and futures currency prices are related, note that holding the foreign currency enables the investor to earn the risk-free interest rate (R f) prevailing in that country while the domestic currency earn the domestic riskfree rate (R d ). Since investors can buy currency at spot rates and assuming that there are no restrictions on investing at the riskfree rate, we can derive the relationship between the spot and futures prices. Interest rate parity relates the differential between futures and spot prices to interest rates in the domestic and foreign market.
The valuation of a treasury bond futures contract follows the same lines as the valuation of a stock index future, with the coupons of the treasury bond replacing the dividend yield of the stock index. The theoretical value of a futures contract should be �
If the futures price falls outside this bound, there is a possibility of arbitrage and this is illustrated in Figure 11.2.
PVC = Present Value of coupons during life of futures contract
S = Spot level of index y = Dividend yield over lifetime of futures contract as % of current index level
This vanished over a period of time. With the introduction of futures, a new kind of arbitrage came into being which is referred to as cash future arbitrage strategy.
You can realize the profit on arbitrage by unwinding your trade; that means you reverse your long position in equity and your short position in futures ...
The word arbitrage has different connotations. At a conceptual level, it refers to the differences in prices. When the NSE commenced operations in 1994, there used be huge difference in prices of the same stock between the BSE and the NSE. Brokers would buy the stock at a lower price on one exchange and sell at a higher price on the other exchange.
As we are aware, stock futures have a monthly expiry cycle and expire on the last Thursday of every month. At any time, there are 3 monthly contracts viz. the near month, mid-month and the far month. In stock-futures arbitrage you buy in the cash market and sell the same stock in the same quantity in the futures market.
You can hold on to your cash market position in your portfolio, but you can roll over your futures position to the next contract based on the spread
What is interesting to note is that you do not have to wait till the date of expiry to unwind your position. You can even unwind your arbitrage earlier if the spread has come down substantially.
Arbitrage-free valuation is the value of an asset or financial instrument based solely on the real performance or cash flows that it generates. When an asset’s market price differs from its arbitrage-free value, then an opportunity for arbitrage exists by trading the asset for another asset or portfolio of assets that replicate its underlying performance or cash flows or by buying and selling the assets in different markets where the price differs.
Arbitrage can only occur when some price difference exists between market prices for an asset or between a market price and the underlying value of the asset. For a stock, the firm is doing the same work and has the same underlying capital structure, asset mix, cash flow, and every other metric regardless of what exchange it is listed on ...
Exploiting price differences in different markets is known as arbitrage —it is a hallmark of business and stock trading.
You can take advantage of exchange rates, futures, and various other forms of investments where the market price does not account for all the revenues and expenses linked to a given asset. But doing so depends on staying alert and discovering opportunities to profit from spreads between arbitrage-free implied prices and market prices, which may be very short lived as all traders compete to exploit these same opportunities.
Exchanges and trading platforms often do not allow for risk-free arbitrage trades and information technology has eliminated a lot of arbitrage profits.
Arbitrage is more useful for traders rather than investors.