Arbitrage is an integral part of the pricing of derivative securities like futures and options.
Arbitrage is an integral part of the pricing of derivative securities like futures and options. As the saying in economics goes, �there is no free lunch�. The absence of arbitrage is a sin qua non for deriving a pricing relationship between the spot price of an asset and its futures price. If the futures contract is overpriced, then traders will resort to cash and carry arbitrage.
This requires that they borrow and acquire the asset in the spot market and, simultaneously, go short in a futures contract to lock in an assured selling price at a future date. If the contract is underpriced, they will resort to reverse cash and carry arbitrage. These strategies require them to short sell the asset and invest the proceeds at the risk-less rate. Simultaneously, they need to go long in a futures contract to cover the short position at a future date at a price that is known since inception.
While cash and carry arbitrage poses relatively less obstacles in practice, reverse cash and carry arbitrage need not always be an impediment-free task. Every underlying asset may not be easy to sell short. In derivatives parlance, we make a distinction between pure or investment assets and convenience or consumption assets. A pure asset is one that is held largely for investment purposes. Financial assets and some physical assets fall in this category.
Let us assume that you have a stock and your desired holding period is one month. If you were to be assured that a potential borrower will return the asset at the end of the holding period, and will also compensate you for any income that you are likely to lose in the interim by lending the security, such as cash dividends, you will not be reluctant to lend the asset to facilitate a short sale.
However, consider an asset like wheat. A wheat mill owner may build up his stocks prior to a harvest. From an economic standpoint, this may appear senseless. For, if the harvest was to be good, then, subsequently, the spot price of the commodity will decline. Consequently, the mill owner not only has to incur storage costs, he also faces the risk of a potential capital loss. However, the mill owner may choose to hold the asset to avoid a potential stock-out due to a monsoon failure or a natural calamity such as a cyclone.
This requires that they borrow and acquire the asset in the spot market and, simultaneously, go short in a futures contract to lock in an assured selling price at a future date. If the contract is underpriced, they will resort to reverse cash and carry arbitrage. These strategies require them to short sell the asset and invest the proceeds at the risk-less rate. Simultaneously, they need to go long in a futures contract to cover the short position at a future date at a price that is known since inception.
While cash and carry arbitrage poses relatively less obstacles in practice, reverse cash and carry arbitrage need not always be an impediment-free task. Every underlying asset may not be easy to sell short. In derivatives parlance, we make a distinction between pure or investment assets and convenience or consumption assets. A pure asset is one that is held largely for investment purposes. Financial assets and some physical assets fall in this category.
Let us assume that you have a stock and your desired holding period is one month. If you were to be assured that a potential borrower will return the asset at the end of the holding period, and will also compensate you for any income that you are likely to lose in the interim by lending the security, such as cash dividends, you will not be reluctant to lend the asset to facilitate a short sale.
However, consider an asset like wheat. A wheat mill owner may build up his stocks prior to a harvest. From an economic standpoint, this may appear senseless. For, if the harvest was to be good, then, subsequently, the spot price of the commodity will decline. Consequently, the mill owner not only has to incur storage costs, he also faces the risk of a potential capital loss. However, the mill owner may choose to hold the asset to avoid a potential stock-out due to a monsoon failure or a natural calamity such as a cyclone.
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