Cash-N-Carry explained

Trader has selected a stock called ‘ABC’ and he wants to do cash-and-carry arbitrage for this stock. Assume that, typically, this stock is priced in the spot-market at Rs.100 and it is priced in the future-market at Rs.104.
For example,
End of Day Spot (Apr-01-2009) Price for RELIANCE (NSE) = 1,581.25
End of Day Future (Expiry Apr-30-2009) Price for RELIANCE (NSE FnO) = 1585.05

Goal of Arbitrage: to make a profit of Rs. 3
This type of arbitrage has 2 transactions: the 1st Xaction will involve ‘selling the future & buying the spot’ and the 2nd Xaction will try to square-off the position (to get out of the 1st Xaction) so that at the end, the trader is not holding any inventory.
Xaction #1: Sell the Future, Buy the Spot
Obviously, the trader thinks that, sometimes, the price of ABC in the future-market (Pft1: Price of future during transaction #1) goes above Rs. 104 (which is the fair price: Pf). So, we need to monitor the data feed to detect the situation when Pft1 is trading at or above (Pf +3), remember 3 is the profit-goal (Pg), ie. Pft1 >= (Pf + Pg).
So, in our example of stock ABC, we will be monitoring to detect the situation, when the price of ABC in the future market is >= (104 + 3) = Rs. 107. Let’s assume that, we detect a situation, where ABC is trading at Rs. 110 in the future-market and it is trading at Rs.100 in the spot-market. So, we will immediately execute the following pair of trades:
Trade1.1 Sell future at 110: cash inflow = 110
Trade1.2 Buy spot at 100: cash outflow = 100
Net profit in Transaction #1 (NP1) = 10
Xaction #2: Buy the Future, Sell the Spot
Now, in Xaction #2, we want to square-off our positions, so that, we can zero-out our inventory and preserve our profit-goal (Pg) of Rs. 3. We know for sure that, sooner or later, the future-price of ABC will become Rs. 104 (which is the fair price: Pf). So, we will be monitoring both the spot-price (Pst2: Price of spot during transaction #2) and the future-price (Pft2: Price of future during transaction #2). If (Pft2 – Pst2) is less-than-or-equal-to (NP1 – Pg), we will execute the trades. In our example, (Pft2 – Pst2) >= (10 – 3) = 7.
So, lets say, we detect a situation, where, the future is trading at 107 and the spot is trading at 100, so, (Pft2 – Pst2) = (107 – 100) = 7. This satisfies the condition: (Pft2 - Pst2) <= (NP1 – Pg), so, we will immediately execute the following pair of trades:
Trade2.1 Buy future at 107: cash outflow = 107
Trade2.2 Sell spot at 100: cash inflow = 100
Net loss in Transaction #2 (NL2) = 7
So, our overall profit for both Xactions #1 & #2 is (NP1 – NL2) = (10 – 7) = 3. Mission Accomplished!!

Tutorial on CashNCarry Arbitrage

http://www.oup.com/us/ppt/derivatives/DMCH05.ppt

cash-and-carry Basics

cash-and-carry Basics

Futures price = Spot Price + Carry Cost - Carry Return
F = S + CC - CR

Carry cost (CC) is the interest cost of holding the underlying asset (purchased in spot market) until the maturity of futures contract. Carry return (CR) is the income (eg, dividend) derived from underlying asset during holding period. Thus, the futures price (F) should be equal to spot price (S) plus carry cost minus carry return. If it is otherwise, there will be arbitrage opportunities as follows.

When F > (S + CC - CR): Sell the (overpriced) futures contract (sanjay: you have to buy it first to be able to seel it ! sel-short ? shorting future contact is allowed ?), buy the underlying asset in spot market and carry it until the maturity of futures contract. This is called "cash-and-carry" arbitrage.

When F < (S + CC - CR): Buy the (under priced) futures contract, short-sell the underlying asset in spot market and invest the proceeds of short-sale until the maturity of futures contract. This is called "reverse cash-and-carry" arbitrage.

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