Can someone help me understand what ‘cash-and-carry’ means in commodities futures context.
If the futures contract is priced higher than the commodity + cost of carry, cash-and-carry arb happens when you buy in the cash market, short the futures contract, and then deliver the commodity to satisfy the short position.
It’s also a 3 Stooges movie.
Hi Busy. if the spot price of a commodity(including costs associated with storing the commodity) is cheaper than the futures price, arbitrage may be possible. In this situation you can buy the commodity and at the same time sell the futures contract on that commodity. As you can see, you bought something for less money and got more money for it through the futures contract. The cash that you receive for the commodity from the futures contract today must be sufficient to cover the storage/carry costs associated with the commodity that will be delivered by you at contract expiration (since you will need to store it until expiration date when you will deliver it to the party that bought the contract from you). Hence the term cash-and-carry.
annadru Wrote: ------------------------------------------------------- > Hi Busy. > > if the spot price of a commodity(including costs > associated with storing the commodity) is cheaper > than the futures price, arbitrage may be possible. > In this situation you can buy the commodity and at > the same time sell the futures contract on that > commodity. As you can see, you bought something > for less money and got more money for it through > the futures contract. The cash that you receive > for the commodity from the futures contract today > must be sufficient to cover the storage/carry > costs associated with the commodity that will be > delivered by you at contract expiration (since you > will need to store it until expiration date when > you will deliver it to the party that bought the > contract from you). Hence the term cash-and-carry. Two problems with that: 1) " The cash that you receive for the commodity from the futures contract today" - when you short a futures contract (unlike shorting a stock) there is no cash exchanged except as a margin deposit with your broker. 2) " when you will deliver it to the party that bought the contract from you" - this is a forward contract. A futures contract doesn’t have a counterparty and when you deliver the commodity, the clearinghouse will pair you up with a long who wants to take delivery.
Hi Joey, I guess i was just trying to simplify so that the topic can be easier grasped. But your points a 100% valid
Let me see if I can say it similarly, but shorter (just trying). If you bought the contracted amount of a commodity today (at today’s price) on borrowed money (at risk-free rate) and sold it at whatever time the future is due, you should get exactly enough money from settling the future at the future’s price to pay back the loan you took. If it’s not that price, then you can do some kind of arbitrage: if the future is overpriced, you sell it, buy the commodity now on borrowed money, and pocket the difference at expiration when you deliver your commodity. If it’s underpriced, you do the opposite: buy the future, sell the commodity now, put the proceeds in the bank (or a t-bill), and use it to settle the future (and pocket the difference). Now actually, there are a few additional things you need to include in getting the price right. If it costs $$ to hold and deliver the underlying, you need to deduct those cumulative expenses from the futures price, and if there are benefits to holding the underlying (like dividends or coupon payments or something), then you need to add those to the price. But the basic thing you should carry around in your head is that the futures price for something (other than a currency, which has an extra twist), is today’s spot price projected forward at the risk free rate. Other things equal, it should be higher than today’s spot price, and go higher the further out you go.
^That’s a convenient way of looking at it, but it doesn’t really apply to commodities. The big problem is that you can’t short most commodities so the reverse cash-and-carry doesn’t really work. For example, you can price out how much it costs to raise hogs to deliver under the contract but there is no way I can think of to borrow hogs and go short.
^ I was thinking about this as I wrote… how do you short in the spot market. I’ve seen traders short things they don’t own, but they usually have to close out at the end of the day. Currencies can be shorted, stocks, can be shorted, probably bullion can be shorted in the spot market, but I was wondering how you short wheat, other than open a margin account and have some kind of paper debit that you pay interest on to another owner. Thanks for dosing a bit of reality here. Do you have any experience how the inability to short affects the futures contract prices? Seems that it would be biased downwards, since you can arbitrage if the future is overpriced, but not so much if underpriced.
It just appears in futures prices like convenience yields (I’ll pay you extra for copper now) or seasonal differences (I’ll pay more for corn now than after the crop comes in). The question is whether you believe that futures markets can be efficient without some arbitrages being possible…
Seems to me that there are two kinds of futures markets: arbitrageable, and non-arbitrageable (like residential real-estate futures). The arbitrageable ones are the ones where one can buy and sell at the spot rate easily. The non-arbitrageable ones are where there are large or insuperable transaction costs in realizing arbitrages. [interestingly, the pigs example might be a semi-arbitrageable future: you can arbitrage if the future is underpriced, but not if it’s overpriced] Arbitrageabe futures are not necessarily indicative of expected future prices, because future prices are pretty much determined by costs of interest, today’s spot prices, cost of carry, etc…, whereas the expected futures price may be affected by a number of other things that the arbitrage doesn’t consider. You can presumably make money if you have a good model to predict future expected spot prices, but this wouldn’t be a riskless arbitrage. Non-arbitrageable futures are not constrained by arbitrage mechanisms and therefore presumably reflect the market’s best estimate of future spot prices. Now those estimates may or may not be any good, biased, whatever, but it seems to me that prices are either a best estimate, or they are fixed by an arbitrage mechanism. I suppose if there is a band of non-arbitrageability that reflects bid-ask spreads and differential rates for borrowing and lending, then there is potentially some influence of future expected spot prices on which prices are available within that range. And of course, over the short term, there may be supply and demand distortions too, but these are the things that are supposed to be “arbitraged away”, at least for arbitrageable futures. Anyway, I’m not laying this out as “the way things are,” but just how I understand it. If people want to correct me or add to this, I’m interested in learning as much as I can about it.
Sounds good to me.
I have question related to this thread: CFAI book Vol 4 page 429 question 3: Using forward price of $2.65, the solution in the back shows that there is a positive storage cost. In other words in this reverse CandC, the investor who shorted the commodity and went long the forward receives cash for storing corn. How does the investor store corn, he/she in theory “borrows corn, sells it short and invests the proceeds at risk-free”. I simply could not understand why there is a positive storage cost and why the investor will not have to pay the lease rate for borrowing the commodity. Any thoughts are appreciated.
Well, I can’t see the book but of course it costs money to store corn. Probably there is a convenience yield for corn in the problem - people will pay more for it now than they will later.