Blog #32 - Cash & Future Arbitrage

 

Cash & Future Arbitrage

Cash & Future Arbitrage

As I began writing this blog, I was watching highlights of a cricket match in which Indian batsmen were thrashing Australian bowlers all over the park. I mention this as I see an important analogy between cricket and trading in the stock markets. In batting, they say the job of opener is to see off the new ball so that a foundation is laid for the middle order batsmen to get a big total. 

 

 

Cash and Future Arbitrage

 

Similarly, in trading it’s important to see off some of the choppy sessions, overbought periods or periods of uncertainty so that when the market again resumes trending, traders can back into the market. Knowing when not to trade is perhaps as important as knowing when to trade.

 

 

All experienced traders would recall the expensive mistakes they made at times when it would have been better to have kept out instead of taking unacceptable risks. It is perhaps the pressure of “idle cash” that makes traders take risks that they should not.  This pressure can be eliminated by taking advantage of the arbitrage returns offered between the cash and the derivative market. The return can be of the order of 15 to 22% annualized risk free, hardly something to be sneezed at when your cash is idling any way.

 

 

The cash and future arbitrage is a strategy which often offers risk free returns at rates better than savings account deposits and most other risk free liquid asset classes. 

 

 

The future price of any security, or the index, is a combination of two factors; the cash price of the asset and the cost of carry for period remaining to expiry of future instruments. In Indian stock markets the cost of carry currently varies between a negative 35% per annum to a positive 35% per annum. It can even be higher of lower than the 35% figure but that would be an extraordinary event. The method of capturing this risk free return is simple.

 

 

Future Prices Higher Than Cash Price

We all know that at expiry the futures price closes at the cash price of the security or index. So in any share if the future price is higher than its cash price you can buy that share and sell a similar quantity of that share. This will allow you to earn the cost of carry of that share. Future prices are generally higher than cash prices in an overbought market.

 

 

Cash Price Higher Than the Futures Price

Intuitively, the cost of carry should always be a positive figure. In the Indian markets, however, we often see futures price being lower than the cash prices generally in an oversold market. This may be due to the fact that Indian market is cash settled and not delivery settled, so the futures price is more a reflection of sentiment, rather than that of financing cost.

 

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