When do I employ carry trade, calendar spreads and reverse carry trade arbitrage?

[John Naronha]

[Ignatius Bose]

Arbitrage opportunities are generally low risk, market neutral strategies and they arise due to a number of reasons. Although strictly attributed to pricing inefficiencies due to the sudden rise or fall in demand in the cash and derivatives markets, the derivatives pricing formula plays a crucial role in establishing arbitrage opportunities. Even though these strategies are considered risk-free, they have to be scrutinized before implementing, since there are other costs associated with the markets such as brokerage, taxes and margins and a change in any of these costs can negatively impact the outcome of the strategy.

Cash and carry arbitrage-

Cash and carry arbitrage, also called “carry trade,” is a combination of buying the underlying security in the spot market and simultaneously selling/shorting the futures contract of the same underlying. The arbitrage opportunity arises when the futures price of the underlying security is trading at a premium to the cash price (also called “contango”), which should generally be the case because the prices of a futures contract are the sum of carrying the underlying security until the expiration of the contract. However, when futures prices increase more than the spot prices plus the cost of carry, it gives rise to price inefficiencies between the two, leading to carry trade where risk-free profits can be earned since, on the expiry of the futures contract, futures prices merge with the prices of the underlying security.

How to use the strategy?

• First, ensure that the theoretical value of the futures price is higher than the spot price. In other words, the basis ought to be positive. Basis= Futures price- Spot price
• The cost of buying the security plus the cost of carry should be less than the cost of selling the security in the future.
• The underlying security should be carried until the expiry of the futures contract.
• The security must be delivered against the short futures contract.

Calendar spread-

Calendar Spreads are an extension of “Carry Trade” where the widening or narrowing of spreads between two futures contracts can lead to riskless profits. The strategy involves a combination of two futures contracts on the same underlying with different expiration dates.

If the spread between two futures contracts widens, then the near month is said to be underpriced or inexpensive in comparison to the far month and the strategy would be to buy/long the near month futures and sell/short the far month. On the contrary, if the spread between two futures contracts narrow, then the near month could be overpriced in comparison with the far month and the trade would be to sell/short the near month and buy/long the far month.

To arrive at the fair value of the two futures contracts, calculate the mean and standard deviation for each of the contracts individually and sum them up to arrive at the upper and lower end of the FAIR VALUE range. If the spread rises beyond the higher end of the scale, it is an indication that the near-month contract is underpriced and should be bought while the far month is underpriced and should be sold. On the contrary, if the spread falls below the lower end of the range, it signifies that the near month contract is overpriced in comparison to the far month. Here, the strategy would be to short in the near month futures and go long in the far month.

 Features of Calendar Spread-

• They are market neutral low-risk strategies.
• Can be extremely short-term without the need to buy/sell the underlying security literally.
• The volatility of the strategy is relatively lower when compared to an outright long/short position.
• Since the strategy combines long and short trades, the effective margins are smaller in comparison to an outright futures contract.

Reverse cash and carry arbitrage-

A Reverse Cash and Carry trade comprises of selling the underlying security in the spot markets and simultaneously taking a long futures position in the same underlying security. The condition is also called “backwardation,” and it arises when the futures price of the underlying security is trading at a discount or is lower than the spot price of the underlying security.

How to use the strategy?

• First, confirm that the value of the futures price is less than the spot price. In other words, the basis ought to be positive. Basis= Futures price- Spot price
• The cost of selling the security in the spot market plus the cost of carry (interest earned in this case) should be higher than the price of the futures contract.

[Daniella]

Hello John,

Forex arbitrage entails the concurrent buying and selling of a security in separate markets while following a profit.
Carry Trade
You acquire a currency with a high-interest rate against one with a low rate. Provided your trade remains positive, the broker pays you the interest variation of both currencies for every day you maintain the trade.
Calendar Spreads
It features the purchase and disposal of options sharing strike prices and a primary stock but differing in their expirations. For long calendar spreads, you offload a short-lived option and acquire one with a longer term. Short calendar spreads, however, involve purchasing a near-term and unloading a long-term option.
Reverse Carry Trades
It merges an asset’s short position with its underlying futures contract’s long position. You can enter a position by selling your stocks and simultaneously acquiring an equal futures amount from the same underlying asset. The short-sale earnings should surpass the cost of your futures contract