The cash-and-carry trade offers investors a tactical route to exploit discrepancies in market pricing. This stratagem typically involves holding a long position in a security or commodity, paired with a corresponding short position in a futures or options contract tied to the same underlying asset.

The essence of the cash-and-carry trade resides in retaining the security or commodity until the delivery date specified by the futures contract, ensuring the investor can fulfill the obligations of the short position. By selling a futures contract, the investor effectively secures a temporary position. Through the extended position component of the cash and carry trade, the investor is informed of the anticipated revenue on the delivery date, as well as the cost base of the security.

In practice, the asset procured under the cash and carry trade framework is preserved until the maturity of the futures contract. At this point, it is deployed to settle the short position engendered by the futures contract sale.

Taking bonds as cash and carry examples, the investor accrues coupon payments from the bond alongside potential earnings from reinvesting those coupons. Moreover, the investor is guaranteed a specific price upon future delivery, a cornerstone of the cash and carry trade.

Reverse Cash and Carry Trade

Conversely, the reverse cash and carry trade is employed when the futures are trading at a discount to the spot price. In this scenario, an investor sells the asset in the spot market and simultaneously takes a long position in the futures contract. This tactic is predicated on the convergence of the spot and futures prices by the delivery date, allowing the investor to procure the asset at a lower price via the futures market.

The success of the reverse cash and carry trade relies on the relationship between the revenue from the asset sale in the spot market and the cost to repurchase it in the futures market. When executed correctly, this strategy can yield significant returns, highlighting the intricate balance and potential of arbitrage opportunities within financial markets.

Workings of a Cash-and-Carry Trade

The core principle of the cash and carry trade rests upon exploiting the pricing discrepancy between an underlying asset and its future derivative. This form of trading is alternatively recognized as a basis trade, where 'basis' delineates the disparity between an asset's spot price and its future price. Traders leverage this variance in the cash and carry trade to derive an advantage.

The methodology underpinning the cash and carry trade is straightforward:

• The trader identifies two securities that are mispriced about one another — specifically, the gap between the asset's current value and its future derivative's price.
• Subsequently, the trader acquires the underlying asset and concurrently sells the futures contract, holding onto the asset until the contract reaches expiration and can be delivered.
• The crux of the strategy is that profit is realized if the initial purchase price of the asset, combined with the cost of carry, is lower than the selling price of the futures contract.
• With the long position established, the investor typically has a clear projection of the potential profit on the contract's delivery date, taking into account the cost of the asset, thereby securing a margin of profit through the cash and carry trade. Nonetheless, the actual profit hinges on the relative pricing of the asset and its futures contract.

Cash-and-Carry Trade Tactics in Credit Derivatives Markets

Basis trading, synonymous with the cash and carry trade, helps navigate the implied interest rates that emerge from such positions, often offering more attractive terms than conventional borrowing or lending avenues.

In the credit derivatives arena, the application of this strategy is significant, where 'basis' may refer to the spread difference between credit default swaps (CDS) and the corresponding bonds for a single debt issuer with matching maturities. Such trades are designated negative basis trades when the CDS spread is narrower than the bond spread, suggesting a 'negative basis.'

Typically, these transactions are executed with bonds priced at par or a discount, paired with a single-name CDS that matches the bond's maturity. The complications of cash and carry examples in this sector illustrate the broader applicability of the trade beyond traditional commodities and securities markets, demonstrating its versatility in sophisticated financial landscapes.

Cash-and-Carry Trades within the Options Marketplace

The options market presents unique avenues for carry trades, notably through mechanisms such as box spreads. Box spreads serve as instruments for securing synthetic loans, offering borrowing or lending opportunities at implied rates that are often more beneficial than those available through prime brokers, clearing firms, or banks. The intrinsic value of a box spread at expiration equates to the range between the strike prices engaged in the trade—a concept that mirrors the properties of a zero-coupon bond.

In essence, the cash and carry trade materializes through the purchase price of the box spread today, representing the loan's principal. In contrast, the difference in value from the strike prices' distance embodies the interest or carry of this synthetic loan.

For example, a box spread executed in the S&P 500 using 1,000 and 2,000 strike prices will hold an intrinsic value of $1,000 at expiration. Should the market price of the spread be $1,050, the extra $50 is indicative of the implied interest rate and constitutes the cost of carry.

Example of a Cash-and-Carry Trade

Let us consider a practical example of a cash and carry trade: An investor identifies an asset on the market with a spot price of $100, whereas the corresponding one-month futures contract is quoted at $104. Suppose the aggregate monthly carrying costs—encompassing storage, insurance, and financing—are $2. Here, the investor would embark on a long position by purchasing the asset at $100 and simultaneously open a short position by selling the one-month futures contract at $104.

The investor's total expense for acquiring and maintaining the asset amounts to $102. However, by locking in a future sale at $104, the investor has crafted a scenario ensuring an arbitrage gain of $2 upon delivery against the futures contract at its expiration.