Cash and Carry Arbitrage- Borrow Cash?

Hi Everyone-

One thing that is really confusing to me is that sometimes the book borrows money to carry out a cash-and-carry and othertimes they don’t. For example, if you look at the problems for reading 33, they borrow cash for problem 1 but not for problems 2 and 3. Am I the only one who’s confused by this? If anyone has any insights as to when we’re supposed to borrow cash, I’d greatly appreciate it!

It all depends on the value of the futures contract. If it is seen as expensive, you short the futures contract, borrow at the risk-free rate, and buy the asset at the spot market. At the maturity of the contract, you deliver the asset to close the futures contract, and pay off the loan. This is the cash-and-carry strategy. In a reverse-cash-and-carry, the futures contract is seen as cheap, as a result, you go long the contract, short sell the asset on the spot market and invest the proceeds from the sale at the risk-freet rate.

Hi CFAFRM, thanks for your response; however, if you look at the problems in reading 33, in all 3 problems, they short a forward contract and long the commodity at t=0. However, in problem 1, they borrow money at the initial period to fund the purchase (so total money=0) while in problems 2 and 3, they didn’t (so total money is negative at t=0). This does not seem consistent to me. As an aside, my understanding of arbitrage is that you should always be able to conduct it without spending your own money, so the total should always equal 0 at the initial period. Any insights?

The reason why they didn’t borrow was that the question was asking for the annualized return. You would have to have an upfront cost to calculate annualized return. In question one, they didn’t say to calculate annualized return (I guess the assumption is that you are doing arbitrage), therefore you borrow. In question 3, they again asks for arbitrage, and therefore you borrow. Asking you for return calculation (in percentage) : don’t borrow Don’t ask or asking for arbitrage, profit/loss: borrow

Ok you’re probably right . . . I’ll have to go back and look at these again . . . thanks for your help!

Having just finished this reading myself, I was glad to find this thread. So I have a question on C&C. The reading seems to explain most price movements in terms of interest, storage, convenience and lease cost. Given this, where do contango and backwardation fit in?

Hi Hank- I may be totally off here, but my understanding is that normal commodities will exhibit contango, while backwardation exists when the benefits of holding the asset exceeds the cost (convenience yield exceeds storage costs plus risk free rate).

In the case of contango, which of the three components - CY, storage or interests – accounts for the rising trend line?

In the case of contango of commodities, the big issue is usually storage costs. The problem with most of these simplifications of contango and backwardation is that there just aren’t that many commodities that can be priced using the arbitrages. There are a few problems: a) It’s almost always difficult to short a commodity. Who is going to lend you 12 tons of copper to sell for instance? That means you can’t really do a reverse cash and carry on copper. b) The deliverable is perishable. This is pretty obvious for lean hogs, for example (a stored hog gets too old to deliver) but is even true for things like lumber (you need to deliver freshly shipped lumber not stored lumber). c) The deliverable is different than what you can store. March and September corn for example are different crops. March is about demand from previous crop and Septemebr is about supply of the new crop. That means that most times you see backwardation or contango its more about current market conditions vs expectations for later market conditions than it is about these arbitrage parameters. Now with bond futures or FX futures, it’s all about the arbitrage.

Hi Hank- I think an easier way to think about it is this: All else constant, interest rates will cause future value to be greater than present value (contango) All else constant, storage costs will cause future value to be greater than present value (contango) All else constant, convenience yield will cause future value to be less than present value (backwardation) What actually happens depends on how large each of these factors are for the particular commodity.

Is contango or backwardation largely explained by these three factors, or is it also affected by the ratio of hedgers to speculators? For example, I was once told that agricultural commodities are normally in backwardation because of the greater relative need to hedge risk on the part of farmers. Commodities aren’t my thing, but at least I want to be certain that I understand the CFAI material.

I think this is because when farmers dominate the market & are ready to accept lower future price to ensure selling of their crops. (Backwardation)

However if there is supply shock, buyers will dominate & will be ready to pay more (Contango)