the Wealthy Canadian

Continuing on my previous discussion of futures pricing, I will introduce the concept of arbitrage.

Arbitrage is taking advantage of a price difference in multiple markets.  In the futures market an arbitrage opportunity presents itself when the basis between the spot and futures prices deviates from the normal cost of carry.

There are times when a futures price is more expensive than it should be, i.e. costs more than the spot + the cost of carrying the asset.  During these times an arbitrager could sell futures contract and buy the asset.  This is know as Cash and Carry Arbitrage.

e.g.,
Gold currently costs $1000 / oz, and has an associated cost of carrying (storing, insuring, etc) of $10 / month.
A 3 month gold futures contract, for some reason, currently costs $1060
The arbitrager performs a Cash & Carry by purchasing some gold and selling a futures contract to deliver gold in three months.

cost of gold = $1000
cost of carry = $10/month x 3 months
Income from futures sale = $1060

Net = $30.  Mr Arbitrager made an easy $30.

There are other times when a futures price is cheaper than it should be, i.e., costs less than the spot + the cost of carry.  During these times an arbitrager could buy futures contract and sell the asset.  This is know as Reverse Cash and Carry Arbitrage.

hmm, this may not work quite as slick.  I cannot sell the asset today if I don’t own it!  Don’t worry, you may be able to borrow it from someone else and then sell it:)  Yeah, I know, they may not like you selling their gold, but you will get the gold back because you bought a futures contract.

e.g.,
Gold currently costs $1000 / oz, and has an associated cost of carrying (storing, insuring, etc) of $10 / month.  A 3 month gold futures contract, for some reason, currently costs $940.  The arbitrager performs a Reverse Cash & Carry by:

• borrowing the gold from his girlfriend
• giving her his prized stamp collection as collateral
• paying her rent
• selling the gold
• purchasing a futures contract to receive delivery of gold in three months.

Mr Arbitrager made $100 by selling the gold and buying a cheap futures contract.  However, he will still need to pay rent on the borrowed gold and he loses the enjoyment of his stamps until the gold is delivered.