What is cash-and-carry arbitrage?

Cash-and-carry arbitrage is a way to make money in commodity markets. Commodity markets are places where people buy and sell basic goods like oil, grain, or metal. In cash-and-carry arbitrage, a trader does some special steps to earn a profit.

The basic steps

The trader buys the commodity right now in the spot market. The spot market is where you buy something and get it delivered immediately.
Next, the trader sells that same commodity in the futures market for delivery later. The futures market is where you agree on a price now, but the commodity is delivered in the future.
The trader has to pay some costs:
- The cost of borrowing money to buy the commodity now
- The cost of storing the commodity until it’s time to deliver it
After paying these costs, the trader still makes a profit. That’s cash-and-carry arbitrage.

Why does cash-and-carry arbitrage happen?

Cash-and-carry arbitrage happens because of price differences. The price in the spot market and the price in the futures market are not always the same.

Spot and futures prices

In a perfect market, the futures price should be equal to:

The spot price
Plus the cost of borrowing money
Plus the cost of storing the commodity

If the futures price is higher than this, there’s a chance for arbitrage. The trader can buy at the spot price, pay the costs, and still sell at a higher futures price.

Market imperfections

Markets aren’t always perfect though. Prices can be different for many reasons:

Not everyone has the same information
It might be hard to buy and store large amounts of a commodity
Borrowing money might be expensive or difficult for some traders

These imperfections create opportunities for cash-and-carry arbitrage.

An example of cash-and-carry arbitrage

Let’s say a trader is looking at the oil market.

Checking prices

The spot price of oil is $50 per barrel right now.
The futures price for delivery in 3 months is $55 per barrel.

The trader calculates the costs:

It will cost $1 per barrel to borrow money for 3 months.
It will cost $2 per barrel to store the oil for 3 months.

Doing the trade

The trader sees an opportunity:

They buy oil in the spot market at $50 per barrel.
They immediately sell oil in the futures market at $55 per barrel.
They pay $1 per barrel to borrow money.
They pay $2 per barrel to store the oil.

Making a profit

After 3 months:

The trader delivers the oil and gets paid $55 per barrel.
They had paid $50 to buy it.
They had paid $1 to borrow money and $2 to store the oil.

In total:

They earned $55 per barrel.
Their costs were $50 + $1 + $2 = $53 per barrel.
Their profit is $55 – $53 = $2 per barrel.

By doing cash-and-carry arbitrage, the trader made a profit of $2 per barrel.

The impact of cash-and-carry arbitrage

Cash-and-carry arbitrage is important for markets. It helps keep prices in line.

Bringing prices together

When traders do cash-and-carry arbitrage, they are responding to price differences. Their actions help to reduce these differences:

When they buy in the spot market, they increase demand and drive up the spot price.
When they sell in the futures market, they increase supply and drive down the futures price.

This process brings the spot and futures prices closer together. It makes markets more efficient.

Providing liquidity

Cash-and-carry arbitrageurs also provide liquidity to the market. Liquidity means there are always buyers and sellers ready to trade.

When they buy in the spot market, they are providing liquidity to commodity producers who want to sell.
When they sell in the futures market, they are providing liquidity to commodity users who want to buy.

This liquidity is important for the smooth functioning of commodity markets.

Risks of cash-and-carry arbitrage

While cash-and-carry arbitrage can be profitable, it also has risks.

Price changes

The biggest risk is unexpected price changes. The trader’s profit depends on the difference between the spot and futures prices. If these prices change unexpectedly, the trade might not be profitable anymore.

For example:

If the spot price increases sharply after the trader buys, they will have paid more than they planned.
If the futures price drops sharply before the trader delivers, they will get paid less than they planned.

These price changes can eat into or even eliminate the trader’s expected profit.

Other risks

There are other risks too:

Storing commodities can be challenging, especially for large amounts or for long periods. There is a risk of damage, theft, or spoilage.
Borrowing money has risks. Interest rates can change. The trader might not be able to pay back the loan if the trade goes badly.
In some markets, it might be hard to find buyers or sellers when needed. This lack of liquidity can make it hard to complete the arbitrage trade.

Traders have to manage these risks carefully when doing cash-and-carry arbitrage.